Value Partners Classic Fund Q3 Letter: Tapping the “through train” opportunitiesVW Staff
Value Partners Classic Fund commentary for the third quarter 2014.
The Chinese equity markets began the third quarter on a bright note as stocks posted strong gains in July and August. However, we saw a steady retreat in September as the release of weaker macro data, combined with political protests in Hong Kong, put additional pressure on the markets. Value Partners (Trades, Portfolio) Classic Fund rose 7.7% in the third quarter while the Hang Seng Index stayed flat and the MSCI China Index was up 1.4%. In the past year, the Fund gained 17.0%. For reference, the Hang Seng Index and MSCI China Index were up 4.3% and 4.6%, respectively, over the same period.
With a turnaround in the Chinese equity markets beginning in late second quarter, we have seen a significant improvement in our fund performance during the third quarter. As the market began to recognize the potential “reform dividends” from investing in state-owned enterprises (SOEs), traditional sectors which show value characteristics have rallied, acting as a tailwind for our investment approach.
Value Partners Classic Fund: SOE reforms gather pace
SOEs are a key part of China’s command economy, representing up to 70% of the constituent stocks of the MSCI China universe. SOEs are trading at lower valuations as investors perceive these companies as less efficient and less profit-focused. To tackle the inefficiencies, the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) announced in mid-July a pilot program to improve the management, supervision and efficiency of SOEs. Companies are required to start adopting more market-based compensation plans to encourage better alignment of corporate and shareholder’s interests. The response has been positive. In the past few months, a number of companies have been reducing their capital expenditure as management started to focus more on the bottom line.
We believe the roll-out of reforms will take place gradually instead of being a one-off measure. Reforms will be seen most notably in industries such as natural resources and alternative energy – areas that we already have positions- and benefits from such reforms can be manifold. For example, PetroChina Company Limited (HKG:0857) (NYSE:PTR), one of our key resources plays, has shown stronger commitment in improving profits this year. It has been reducing capital expenditure and shutting down inefficient refineries on the one hand, and undergoing an austerity program to reduce entertainment expenses on the other hand. In addition, it is also enhancing corporate governance, while introducing private capital and planning to sell selected pipeline assets which were previously unavailable to private investors. Finally, as we mentioned previously, PetroChina may benefit from the gas price reform, potential adjustments to tax, as well as supportive policies for shale gas development. While some investors remain skeptical of the SOE reform conviction in the energy sector after witnessing the sale of Sinopec Shanghai Petrochemical Co Ltd (HKG:0338) (NYSE:SHI)’s marketing division to domestic investors, we believe the opening up of the sector to private capital and foreign investors will likely be gradual and hence takes time for the market to fully recognize.
Value Partners Classic Fund: Tapping the “through train” opportunities
While reforms are expected to continue to support the market in the medium term, the upcoming Shanghai- Hong Kong Stock Connect program is likely to act as a near-term catalyst. The “through train” scheme is a landmark opening of investment channels which will let global investors participate in Shanghai-listed securities trading and allow Chinese domestic investors to trade Hong Kong-listed stocks. At Value Partners (Trades, Portfolio), we are very excited about this program which is likely to be launched in late October. We have been closely following the progress and are well prepared to make full use of it.
We look to take every step to generate gains for our investors. In addition to preparing ourselves to take part in the program, we have already positioned our portfolio to take advantage of the potential arbitrage opportunities. Through utilizing various existing and newly granted access quota to A shares, we have substantially increased the Fund’s A-share exposure to 24% currently* from 10% at end-June. While selected dually-listed companies are still trading at discounts ranging from 10% to 15% in the A-share market, this presents an immediate and obvious investment opportunity. The significant additions reflect our focus on value opportunities in the A-share market, an area where experienced Hong Kong investors will focus as the Stock Connect program launches. Meanwhile, we have also deployed capital in traditional value sectors that offer attractive dividend yields.
Value Partners Classic Fund: Luye Pharma shines in booming healthcare sector
During the quarter, we have increased our exposure in our favorite sectors such as healthcare. The rapid growth of the sector is a reflection of aging population and dietary shifts in China. As China is increasingly focusing on the quality of growth, we remain confident that the healthcare sector will continue to grow at 1.5 to 2 times the GDP growth rate as it did in the past, benefiting drug and medical equipment manufacturers.
Our additions in the healthcare sector continued to do well in the third quarter and made significant contributions to portfolio return. One example is Luye Pharma Group Ltd (HKG:2186), one of the largest drug manufacturers in oncology, cardiovascular system, and alimentary tract and metabolism – the faster-growing segments in the healthcare sector. With a strong product pipeline over the next three years, together with four upcoming drug trials in the U.S., Luye is well positioned within the sector. Its recent initial public offering (“IPO”) has also provided the company with capital to purchase Jialin, a local cardiovascular drug manufacturer. Jialin’s drug portfolio can leverage Luye’s existing distribution network, giving us more confidence in Luye’s ability in growing market share. Since our participation in Luye’s IPO in early July, it has been one of the top 10 positions in our portfolio. The company’s share price gained over 65% in the third quarter.
Value Partners Classic Fund: Hong Kong protests
While we remain pro-active with our portfolio fully invested, Hong Kong has been in newspaper headlines on the political front. In late September, we witnessed a political divide accompanied by mass street protests. As Hong Kong society became increasingly polarized, some investors took profits, causing a retreat in Hong Kong share prices. The protests certainly have hurt certain local industries such as retail, tourism, and property landlords, but have little or no impact on Chinese businesses which make up the majority of our portfolio. In fact, local Hong Kong exposure is estimated to be at only around 2% of our portfolio. As usual, we will be monitoring the situation carefully.
We think there is a reasonable chance that the unrest in Hong Kong will have only a temporary impact on local shares, but we are fully prepared for a bad-case scenario where the negative impact could be a lot longer-lasting but largely confined to Hong Kong. Although based in Hong Kong, Value Partners (Trades, Portfolio) has been dedicated to investing across the Greater China region, and since the late 1990s has spread out across the Asia Pacific Region. Like many well-diversified investors, we wish Hong Kong well but we are not overly dependent on it.
As market sentiment has improved, we have seen significant positive inflows to our funds during the quarter. We thank our investors for their continued support and will remain focused as ever on delivering performance for clients through our value investing approach.
Value Partners (Trades, Portfolio) Investment Team
13 October 2014
* Including exposure from both direct A-share investment and indirect investment through China A-Share Access Products (CAAPs).
Fund performance mentioned referred to Value Partners (Trades, Portfolio) Classic Fund “A” Unit. All performance figures are sourced from HSBC Institutional Trust Services (Asia) Limited and Bloomberg (Data computed in US$ terms on NAV-to-NAV basis with dividends reinvested) as at 30 September2014. Performance data is net of all fees.
Individual stock performance is not indicative of fund performance.
Investors should note that investment involves risk. The price of units may go down as well as up and past performance is not indicative of future results. Investors should read the explanatory memorandum for details and risk factors in particular those associated with investment in emerging markets. This commentary has not been reviewed by the Securities and Futures Commission. Issuer: Value Partners (Trades, Portfolio) Limited.