Why Skerryvore is underweight to China

Some of the world’s biggest tech names are domiciled in China, but Skerryvore Asset Management is underweight in the Chinese market - an unusual move in an age where Alibaba and Baidu are popular household names.

Glen Finegan, Lead Portfolio Manager at Skerryvore, attributes their lower exposure to two main reasons – state-ownership and the legal structures around big tech.

“We try to avoid investing in state-owned enterprise, of which there are a lot in China. Banks for example, are state-controlled, the oil and gas businesses. A lot of the big businesses in China are state-controlled businesses and we don’t invest in state-controlled businesses in any other country so we wouldn’t in China.”

His concern around legal structures centres around the inability to truly enforce them should issues arise. Foreign investors are unable to own Chinese companies, so structures like Variable Interest Entities (VIEs) are used instead to mimic ownership by offering you a contract for returns from the performance of a company (by contrast, shares offer you direct ownership which entitles you to returns).

In this edition of Expert Insights, Finegan discusses Skerryvore’s exposure to China along with their watchlist for Chinese companies to hold in the future. He also explores one of the portfolio holdings, Hangzhou Tigermed Consulting, which runs drug trials in China.

Key takeouts:

• Skerryvore avoids state-ownership, which has reduced the investment pool available in China.
• Legal structures like VIEs are also a concern for ownership because of the difficulties of enforcing them if needed.
• There are still opportunities in the Chinese market, with healthcare a sector of interest.

Edited transcript

Why does Skerryvore have a limited Chinese exposure compared to its benchmark?

We've got limited exposure to China at the current time. Look, there are a few reasons for this. Certainly, at around about 5% of the portfolio, the benchmarks obviously considerably more than that. I think there are a few things to highlight. So, we try to avoid investing in state-owned enterprises, of which there are a lot in China. All of the banks for example are state controlled, the oil and gas businesses. So, a lot of the big businesses in China are state controlled businesses. We don't invest in state controlled businesses in any other country, so we wouldn't invest in state controlled businesses in China.

Why have you avoided investing in the big tech names in China?

Another large part of the China market has been the technology sector. So, names like Alibaba and Tencents, that are well known. We've not invested in those companies because of the legal structures around them. So, it has been the case that the Chinese government law, says that foreigners should not invest in internet, media, education sectors. So, how on Earth are these companies listed? How are people investing in them? It's because they've got lawyers to help them raise money overseas, they've created very complex legal structures that don't technically control the underlying Chinese businesses. But have promised a contract that they'll be allowed to share in the profitability, the growth of the underlying Chinese business. But these would not really be enforceable under Chinese law because foreigners aren't really meant to own these businesses.

So, that's just a compromise that we wouldn't make. We want to invest in businesses where we can own real equity. We ideally want to own exactly the same equity as the founders, the family, the management teams, we want to be aligned. These structures have never looked to us to afford a particular level of alignment. I think investors got a bit of a shock when the Chinese government announced that the education sector should not be profitable, it should be a non-profit sector. The value of the VIEs, which is the name of these legal structures, collapsed. But ultimately, the legal ownership between the VIE and the underlying companies in China, was always pretty tenuous anyway. So, I think that was more a case of a risk crystallising than something particularly unpredictable. So, we haven't invested in that sector, because we try to avoid those complex legal structures, which don't properly align foreign minority shareholders like ourselves, with the people behind the businesses that we would like to invest in.

Do you still see opportunities for investment in China?

Our opportunity set in China is probably a little bit smaller than what the benchmark might suggest is there, because of SOEs and these VIE-type structures. That said, we are growing a watch list in China. Obviously it's a huge economy, it's a sophisticated economy, and there are pockets of the economy where there are private businesses building what look like defendable franchises that could prosper for a long time. So, just to give an example of the most recent addition to our strategy, a business called Hangzhou Tigermed. It's a CRO, Clinical Research Outsourcing organisation. So, it assists companies who are developing drugs, it runs drug trials. So, it's not taking the risk of success/failure of a drug, it's running trials. China is very keen to have its own domestic drug industry, drug development industry, and multinational companies are trying to have drugs approved there as well as domestic companies. So, there's lots of trial activity, and that means lots of outsourcing and growing outsourcing.

Currently, only around 10% of drug development spending is outsourced in China. In the US, it's 40%. So, the opportunity for that sector, the CRO sector, to become much bigger is there. As a drug developer, you will only work with a trials operator that you trust. You're going to trust them with your data, you've got to trust they're not going to steal your intellectual property and give it to somebody else. So, we think that the most successful company in that sector is going to be the one that people trust the most. If you're trusted, you can infer something about the integrity of the people behind the business. So, we think there are pockets of defensive growth that aren't linked to the property sector, which clearly has problems, the banking sector, which probably has problems because the property sector has problems. So, not linked to those, more defensive parts of the economy, like drug development, we've been interested in adding the occasional name to the portfolio.

What would lead you to increase the allocation to China?

In the case of China, our watch list has grown steadily over the last say three years. But the weightings in our portfolio in China have actually come down, because if you go back 12, 18 months, we would've told you that China's in a bubble, that valuations of domestic names that we think might be interesting are so extraordinarily above what seems reasonable that the watch list is growing, but the portfolio, we're actually selling holdings because of valuation. What we've seen since February last year is a pretty substantial fall in Chinese markets, because they were too expensive. They've fallen a lot. We do think that one or two of the names that we have identified are beginning to reach a point where we might get interested, where we might be interested in moving them into the portfolio.

For us, the right valuation is one where we are able to convince ourselves that the price we're paying affords us the opportunity to compound at between 10 and 12% per annum, over a five-year holding period. That's the valuation parameters that we use. We are at the point now where we think that the value- I mean, the share price of Hangzhou Tigermed, which is the name we mentioned, has halved since the peak last year. It is now reaching a level where that type of return potential might be possible, in our view, based on our forecasts. So, hence we think that justifies a small position in the portfolio. So, it's moved... Other names are still in the monitoring phase, but there is the potential to bring more names in, as valuations improve.

Far-sighted and fair-minded

Skerryvore Asset Management is a boutique of BennBridge, the UK arm of Bennelong Funds Management. The team are fundamental, bottom-up investors seeking to create high conviction portfolios of reasonably valued, high-quality companies that are exposed to, or operate in, emerging markets. For more insights, visit Skerryvore's website.