MegaTrust 4Q17

By Charlie Chen & Qi Wang, Mega Trust Investment

"The hardline stance [on financial regulation] is set to continue as senior leaders agreed to maintain the resolute crackdown on irregular and illegal activities in the financial sector to forestall risks. Although a statement released after the key economic meeting did not mention deleveraging, financial risk control is still a priority given that defusing major risks is one of the three tough battles that the country has vowed to fight." China Daily's on the 2017 Economic Work Conference

"The term 'gray rhino' has become popular in China after the National Financial Work Conference last month. It refers to large and obvious problems that are ignored until they start moving fast, as compared to black swans that refer to highly unpredictable and unexpected events. Now, what are those gray rhinos in China at the moment? Well, property bubble, local government debt and shadow banking are some of them." EJ Insight

Fund Performance - 4Q17

Yangtze Fund II Portfolio - 4Q17

Note: SOE stands for state-owned enterprises.

The MegaTrust Yangtze Funds all gained around 2% in December and 10% in 4Q17, amid rising volatility of the China A-share market. The longest running Yangtze Fund II returned 24% in 2017, beating the MSCI China A Index by 11%. Meanwhile, the newly launched Yangtze Fund IV (Cayman) is up nearly 8% since inception on July 31, also beating the benchmark during the same period.

The MegaTrust Yangtze Fund IV is our first and only Cayman fund based on the same proven strategy of the Yangtze Fund II & III. This is an open-end fund offering monthly liquidity to global investors, and trades China A-shares through Hong Kong Stock Connect. Please email us at info@megatrust.com.hk for enquiries.

2017 Review: A Market of Two Worlds

Our strong performance in 4Q17 is mainly driven by consumption related stocks in the auto, airline, food and beverage industries. The financial stocks in our portfolio were mixed: positive returns of traditional financial companies were offset by corrections in Internet finance related stocks. In addition, the smart-manufacturing and cyclical industry stocks weakened in December following their strong outperformance in November. We increased our equity exposure slightly last month, and took the opportunity to buy more value-oriented, pro-cyclical names, as well as healthcare, semiconductor and electronics stocks. We also shifted our media industry exposure from state-owned enterprises (SOE) to more Internet savvy players in this space.

Looking back at 2017, we got certain things right but other things not so right. Our strong conviction in high quality, consumer industry leaders has paid off. But we missed out the rally in insurance, electronics and home appliance stocks. Also, the SOE reform stocks in our portfolio continued to disappoint and caused a drag on the overall performance. Having said that, we did not make any major mistakes in asset allocation or stock selection. As a result, our 2017 performance not only beat the broad market index (e.g. the MSCI China A Index), but also came in-line with the best-performing sub-index (e.g. the SSE 50 Index).

The Yangtze Fund II vs. Various A-share Market Indices in 2017

Source: Wind and MegaTrust.
Note: Since there is no standard definition of large, small and mid caps in China A-shares, the above indices are used to approximate the performance of various market cap segments. For more information on the CSI indices, please visit http://www.csindex.com.cn/en.

Apart from the returns, the risks of our funds in terms of volatility and drawdown were also lower than usual, due in part to the declining volatility of the A-share market. The annualized volatility of Yangtze Fund II was 6% in 2017, compared to the market volatility of 8% - also at a historical low. The low volatility, along with the relatively low turnover of 140% in 2017, suggests our investment strategy and process have become more reliable and matured.

Despite double digit returns at the index level, 2017 was by no means an easy year for the active managers. A foreign investor recently told us he was surprised to see the major indices up 12-25% last year, while it didn't "feel" like an up market at all. He also regretted not investing in our funds sooner, as the other A-share funds he invested in all lost money in 2017.

Indeed, it was quite possible to lose money last year. The 2017 rally was limited to the mainstream indices and just a few large cap, Blue Chip names. 80% of the 3,000 or so A-share stocks failed to make money in 2017, and the median return of all stocks was -25%. Many small-mid cap stocks continued to make new lows while certain large caps continued to reach new highs… Two completely different worlds.

The Prolonged Torture of Small Caps (The ChiNext Index)

Source: Wind and MegaTrust.

We correctly predicted the bifurcation of the A-share market a year ago, and in subsequent reports thereafter, with snappy titles such as "The Empire Strikes Back" and "Revenge of the Nerds". Of course, the "Empire" or the "Nerds" refer to the large cap, Blue Chip stocks that are striking a dazzling, unprecedented comeback.

In the history of China A-shares, market cap (size) has always been the most important factor for any dispersion. In the 20 years or so leading to 2015, it was the small caps consistently beating the large caps. "Small is Beautiful", one might say. The trend reversed in 2016 and the new motto is "Large is Beautiful". The outperformance of large caps simply reached another extreme in 2017.

Some believe the main driver for the large-small cap bifurcation is earnings. We beg to differ. Just look at the numbers. The top performing SSE 50 Index and CSI 100 Index (large caps) both returned over 25% in 2017, yet the aggregate earnings growth of their constituents was less than 15% last year. This implies multiple expansion contributed to nearly half of their return. Meanwhile, the CSI 500 Index (small caps) saw its aggregate earnings up 50%, while the index was down 13% in 2017. Valuation re-rating was the main culprit.

It is evident that the large cap multiples are expanding, while the small cap multiples continued to contract, moving in exactly the opposite direction. Several factors led to this valuation re-rating, in our view:

(1) The securities regulator is tightening its grip on the market, and tries to strengthen the regulatory framework and crack down foul plays. Drastic new measures on IPOs and secondary placements were launched in the last two years. The improving regulatory environment has benefited Blue Chip companies that have solid fundamentals and abide by the rules. Meanwhile, a large number of small-mid caps find it increasingly difficult to deceive investors using capital market gimmicks. As Warren Buffett said, "It's only when the tide goes out that you learn who has been swimming naked."

(2) 2017 represents the "new normal" in Chinese IPOs, with over 400 companies going public last year. Most of the new IPOs are small companies with market caps below CNY5 billion (US$770 million). The rapidly increasing supply of small-mid cap stocks had a detrimental impact on the sector's valuation premium.

Nearly 500 IPOs in Total in 2017

Source: Wind and MegaTrust.

(3) The changing investor base/behavior is also a driving force. The rise of the institutional investors, including the Social Security Fund, insurance companies, banks and foreign institutions, has caused a secular shift to large cap, Blue Chip stocks. Foreign investors especially have been buying high quality leaders non-stop since the expansion of Stock Connect in late 2016 and MSCI's announcement of A-share index inclusion in mid-2017. The valuation re-rating of large caps is only a natural result of the rising institution ownership, by those investors with extremely long investment horizons.

2018 Outlook: A Scaled-down 2017?

Looking forward, we expect 2018 to be a "scaled-down" version of 2017, following basically the same pattern but perhaps less dramatic.

Steady As She Goes

Our "scaled-down" view has three meanings. First, we expect the major indices to reiterate the same steady patterns seen in 2017, with a more gradual inclination. The regulatory has stated that "the capital market will be an important part of the Chinese Dream". We think the government's policy will continue to foster a stable and healthy stock market going forward.

Policy support is essential but not sufficient. Ultimately, it's the resilience of the Chinese economy that will continue to support the stock market's growth. In measuring this "resilience", we suggest investors paying less attention to the headline GDP numbers and focusing more on the quality of the Chinese economy. No doubt the topline is coming down, but China's economic quality is improving and will continue to improve as part of the country's economic reform. Near-term pain is for long-term gain. The reform will (eventually) provide a major boost to the capital market.

From a bottom-up, microeconomic angle, we are also seeing an increasing number of sustainable, high quality companies emerging as the reform deepens and the New Economy takes shape. Though these companies account for a relatively small portion of the economy, our investment strategy takes concentrated bets and only need 15-30 stocks (as opposed to 150-300 stocks) to work. There will be enough to choose from.

Likely Lower Upside than 2017

The second meaning of "scaled-down" is that the market's upside will likely be lower than last year's. The market enjoyed "Double Happiness" in 2017 from strong earnings growth and significant multiple expansion. However, the magnitudes of both trends are expected to be lower in 2018.

The aggregate earnings growth of the A-share market as a whole reached 20% in 2017, driven by recovery in the upstream cyclicals and continued growth in downstream consumer demand. This creates a high base for 2018, and in light of the mediocre macro-economy, further upside to the aggregate earnings growth seems unlikely.

In terms of multiple expansion, the top four banks is a good example, whereby the average price-to-book ratio increased by more than 30% in 2017. This is extraordinary for large cap banks, in the absence of any extreme events. We think single digit % expansion in 2018 is more reasonable. Banks are not isolated case of slowing multiple expansions. We expect most other sectors to experience similar pace changes in valuation re-rating.

Less Bifurcation

By "scaled-down", we also mean the large-small cap bifurcation will begin to converge in 2018. The spread between the CSI 100 Index (large cap) and the CSI 1000 Index (small cap) was nearly 50% in 2017. A near 50% spread in 12 months is truly exceptional. No one has the crystal ball on what will happen next. But we do know that nothing lasts forever. Whatever goes up must come down (By that, we mean the spread, not necessarily the individual index). And every dog has its day.

If our thesis on the "institutional ownership" of large caps is correct, and assume these institutional investors are value investors to a certain extent, then any further expansion of the spread means large caps will eventually lose its "value allure", at least from a relative value standpoint. Therefore the gap between large caps and small caps will have to narrow at some point.

In addition, investors will increasingly differentiate between the high quality and the low quality companies within the large cap sector. Large cap will no longer be an index play, but more about stock-picking. This means we cannot naively expect the large cap index to rise forever. The same argument can be for small caps, i.e. fallen angles that have come down with the index and present good investment opportunities in 2018. Whether it's in large caps, mid caps, small caps or micro caps, stock picking will be more important going forward. This is a key argument that we've made repeatedly in previous reports. This is also why the China A-share market is the best arena for active managers.

Relative Performance of Value / Growth in A-shares

Source: MSCI and MegaTrust.

Though we expect the large-small cap bifurcation to converge, we do not think it will disappear. We continue to believe the switch from small caps to large caps (and a similar style shift from growth to value) is a long-term secular trend in A-shares.

Likewise we don't think there will be any sustainable style shift (back to growth) in 2018. Today it is rather difficult for institutional investors to make a strategic allocation to the low quality but still high valued small cap stocks. Case in point: the ChiNext Index is current trading at 35x forward PE but with only 10% sustainable ROE. Granted, 35x is a lot cheaper than several years ago when it was trading at over 50x, but still expensive relative to the small caps' poor fundamentals in general.

In summary, 2018 is now upon us but the shadow of 2017 remains. The same forces that drove the 2017 market are still here and unlike to disappear so soon. However, the marginal effects of these factors seem to be diminishing. Therefore, we expect 2018 to be a continuation of 2017 but in a scaled down fashion.

What Are the Risks?

In our annual outlook a year ago, we highlighted three sources of risk, namely the rising interest rate (monetary tightening), regulatory tightening, and the property bubble. For the interest rate risk, the stock market has largely digested the monetary policy impact, in our view, even though rates will remain high for the time being. For the real estate risk, the government has made concerted efforts to contain the bubble through effective long-term policies. These two risks have been reduced significantly.

This leaves us with the regulatory risk, which concerns not only the stock market but also the overall financial system. Based on the recent announcements, the Chinese government is committed to deleveraging, controlling systematic risk and increasing capital control. Such policy developments are important to monitor. Regulatory risk is at the top of our watch list.

Source: CNN.

We noted in our October report that the Sino-US relations also present some uncertainty in the near-term. The current relationship of China and the U.S. is best characterized as "competitive cooperation". Given the differences in economic and political status quo and the different stages of development, there are likely more opportunities (and need) for collaboration than conflicts of interest. Short-term volatility in the bilateral relations may be inevitable. And if any related geo-political risk materializes, it will have a terrible impact on risk appetite and valuation. We do not take this lightly.

Lastly, an emerging yet significant risk to watch for is liquidity. Until recently, liquidity has not been a major risk for A-shares, as this is consistently one of the most liquid stock markets globally (second only to the U.S. and surpassing the U.S. in total trading volume in 2015). In addition, the small-mid caps tend to be more liquid than the large-caps traditionally, which is a strange feature of the A-share market and seldom seen elsewhere.

However, we think the liquidity profile of the A share market is now changing. The market's overall volume seems fine. After all this is still a market with over 100 million investors and China still has the world's largest personal savings. However, the trading volumes of small-mid cap stocks are declining in general, for the same reasons that their valuation and price levels are also declining.

In the best case, the trading volume of small-cap stocks may "normalize" to significantly lower levels. In the worst case, some may become zombie stocks with no meaningful daily trading. Today, we need to assess very carefully whether a small cap stock offers sufficient trading volume for our portfolio (15-30 positions, scalable up to US$2 billion). Since 2017, we have enhanced our liquidity risk management by implementing real time monitoring and forward-looking models.

The changing liquidity profile is another reason that we think the small cap bubble will continue to deflate. The higher liquidity of small caps that commanded a valuation premium previously is contrasted with the deteriorating liquidity which may lead to a valuation discount. This is a big deal.

Percentage of Total Portfolio That Can be Liquidated

Source: Wind and MegaTrust.

Investment Strategy

Since we expect 2018 to resemble 2017, we will apply similar asset allocation and sector / stock selection strategies to our portfolio. Not much change here. The asset allocation will be in line with our historical trend. For sector selection, we will continue to focus on our core competency, including consumer, financial services, smart manufacturing, healthcare services, technology and media. Meanwhile, we will adjust both asset allocation and sector exposures dynamically in 2018 as the road ahead is still filled with uncertainties.

For stock selection, we will continue to focus on high quality stocks at reasonable valuations, and try to avoid the value traps and liquidity traps. One minor change from 2017 is that we will pay closer attention to quality stocks in the technology sector in 2018.

We are also watching the small-mid cap space closely for potential investment opportunities in 2018. This segment has been declining continuously since mid-2015. However, there are bound to be "fallen angels", namely quality stocks that have been sold off during the current small-mid cap correction. If fundamentals improve unexpectedly or other short-term catalysts emerge, these stocks should have a nice run. The QGARP stocks within the small-mid caps may be scarce, but they are the true source of Alpha in 2018. (QGARP stands for Quality Growth at a Reasonable Price).

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