‘Success eventually erases all mistakes.’ The Chinese proverb perfectly captures the perfectionism of high-flying fund manager Bin Shi, who is always focused on correcting and learning from any missteps in his strategy.
Over the past five years, Shi has led the way in the Chinese equity sector, outperforming all his peers with consistent returns from his UBS China Opportunity fund.
The manager has been at the Swiss banking giant for more than 11 years, and runs three Chinese equity funds from his base in Hong Kong.
He has managed the $1,788.41 million China Opportunity fund since July 2010, with a fundamental approach and a market-cap-neutral strategy.
In this respect, Shi explains that he doesn’t pay too much attention to the benchmark, as the fund has an overweight of 30% in small and mid caps.
In his allocation, the Chinese-born manager draws upon both his long career in Chinese equity investing and the experience he gained in US equities between 1999 and 2002.
‘It’s good to have experience in developed markets like the US market, because you know which direction emerging markets like China will go in the long run.’
Shi says he has made his fair share of mistakes with the strategy, but this has made for a steep learning curve. In the long run, it has helped him outperform.
‘In 2011, we digressed a little bit by investing in too many very early stage companies, and a lot of those stocks did not do very well. We reflected hard in 2012 and decided to come back to the core, focusing on leaders and future leader companies that can do well in the long run.’
Having made this decision, the team sold on the smaller names they thought they had made mistakes on, and kept the fundamentally strong companies with a long-term view, regardless of whether they were out of sync with the market at the time.
Within the portfolio, the number of stocks decreased as Shi set up a more disciplined stock-picking strategy. The average number of positions fell from 70 holdings to between 40 and 50 today.
These tweaks to the strategy have been the main drivers of the fund’s success over the past five years, and have created consistency and higher levels of performance since 2012.
‘We learned from our underperformance during that period. I think making mistakes is part of life, but making the same mistake twice cannot be forgiven.
‘We hadn’t fully implemented our strategy before, but now, because we have more confidence in our approach and we have learnt from our past mistakes, we will not digress again like in 2011. As well as we have done against the benchmark, we still feel like there are a lot of things we could do better and ways to improve.’
Navigating a young market
The inclusion of China A-Shares in the MSCI global benchmark indices – marking an improvement in market accessibility and a loosening of controls – is very positive for investors and companies in China, Shi says.
‘We think the inclusion is definitely long overdue, because not including it means the benchmark is probably not very representative.’
Global investors are set to gain from the move, as they will be able to invest in the market for the first time. Even so, Shi’s China Opportunity fund has only one A-Shares stock, representing 0.5% of the portfolio, despite being able to hold up to 10%. ‘The A-Shares market is very immature and sometimes momentum stocks, stocks with no fundamentals, can actually do a lot better than fundamentally sound and reasonably priced stocks,’ he says.
He also notes that it is crucial not to get sucked in by any hype around the young Chinese stocks. This can be tricky when investing in Chinese equities and has led to short-term underperformance in the past. ‘From time to time we can lag the market significantly because our style might not be in favour in the short term. It is a very tough challenge to stick to your principles, filter out all the short-term market noises and focus on the fundamentals,’ he says.
To sustain the long-term performance of the Chinese stock market, we need to see more reform, Shi says. ‘We don’t want to see a strong market if it’s just a short-term event; we want to see a more sustained strong market in the long run and that can only be supported if we do see more structural reforms within the Chinese economy. Any reform will be positive.’
While there has been some reform and the direction has been clear, the pace has been hard to predict, he says, adding that the market is yet to fully discount the expected reforms.
The IT sector is the largest sector exposure within the UBS portfolio, making up 30% of the fund.
Even so, the fund has an underweight compared with the index of 5.4% in the sector, which is largely down to the restriction on individual stocks, Shi explains.
As a mutual fund, the maximum it can own in any single stock is 10%, which restricts exposure to top stocks, including Tencent, which is 15% of the benchmark and Alibaba, which is 12%.
With these two stocks alone, the cap forces the manager to underweight the benchmark by 8%. Without the restrictions, Shi says the fund would likely overweight the sector.
UBS has been invested in Tencent since Shi joined the group 11 years ago, and has benefited from the holding.
The energy space is facing a lot of changes, with many long-established companies coming up against serious long-term risks such as the growth of renewable energy.
Many fossil fuel firms are facing the rise of renewable energy, including wind and solar power, and the prices of these cleaner forms of energy are dropping rapidly.
Shi warns that these sources of power will soon be able to compete with coal-based power. Although fossil fuel firms might be starting to pay attention to solar, by the time they get involved the first-movers will already have staked out their claims on the industry, making it difficult to catch up.
This goes a long way to explaining Shi’s underweight to the energy space, which represents 1.29% of the fund, 3.8% lower than the index position.
The telecommunication sector is one to avoid, according to Shi, who does not have any exposure to it.
Telecom companies are too slow to respond to the market, which is why internet companies are taking the majority of the value added in terms of new services, he says.
They are becoming pipes, he explains, as they no longer know how to take advantage of value added services.
The UBS portfolio has always had an underweight position relative to the benchmark in this sector. Shi has had no exposure to the sector for the past three or four years, which contrasts with the index’s 6.3% exposure.
Shi admits that the fund has occasionally used the sector as a liquidity buffer, investing in China Mobile from time to time when it is very cheap, but says that, as a rule, he avoids the sector.
His decision to reject telecoms makes for one of the fund’s largest underweight stock positions compared to the benchmark, a deviation of -5%.
Insurance companies will do well this year, Shi says, on the back of higher government and corporate bond yields, which will have a positive impact on returns.
Over the long term, the investment team on the China Opportunities fund has been positive about insurance companies.
The penetration of insurance firms in China remains very low, lower than in countries including Thailand, Malaysia and Taiwan and much lower than in developed markets. This means there is still a lot of room for them to grow, Shi says.
‘Last year there was some irrational competition by some of the more aggressive insurance companies, but now regulators have started to pay more attention to the risks so aggressive companies have scaled back operations significantly, which means the traditional strong players are faced with less intense competition this year.’
Shi says he follows closely the leaders in the space, including KI Insurance.
Demographic themes are well represented in the UBS portfolio, Shi says, with a large focus on healthcare and education. He expects these sectors to become even more significant going forward.
As the standard of living continues to improve, people will focus on their health, self-improvement and education. With this upgrade in consumption, there will be a shift towards these two sectors, and away from cars and houses, which are already well represented in the market.
The portfolio’s large exposure to consumer discretionary, at 15.71% (versus an index overweight of 5.3%), is mainly down to holdings in education.
These have proved a ‘surprise win’, Shi says.
The third largest holding in the portfolio is TAL Education Group, which represents 9.26% of the fund – the largest overweight (8.75%) to the benchmark.
The stock is one that the fund has held since it was regarded as a small cap four or five years ago. It now has a market cap of $10 billion.
The healthcare sector shows a lot of promise for the future, Shi says. It even reminds him of the IT sector 10 years ago.
A decade ago, the IT sector was not a big component of the benchmark, but it has since grown to become its largest sector.
In healthcare spending per capita, China is still among the lowest, meaning that there is still a lot of room for growth, Shi suggests.
‘The government effort to control drug prices has put some negative sentiment on the healthcare sector in the short term, but we think that in the long run this sector will continue to do well and you will see some healthcare companies that will be able to consolidate.
‘We actually believe that the leaders will get stronger because the environment is tougher. Usually the weak ones get weeded out first, which means they will leave some market share to be taken by the leaders.’
A new level of quality is increasingly apparent in China too, Shi says, as Chinese regulators are now using international standards to judge the effectiveness of the drugs produced by Chinese companies.
This positive outlook for healthcare is reflected in Shi’s portfolio, as it constitutes 13.32% of the total fund allocation – a large overweight of 11.2% against the index.
In doing so, Shi focuses on firms with strong research and development, as they will do better when judged against international standards, he says.
At present, the portfolio has just two pharmaceutical stock in its top 10 holdings: Livzon Pharmaceutical Group (2.54%) and SSY Group (2.08%). However, there are more pharma names in the fund’s top 15 holdings.
This article was first published in the September 2017 issue of the Citywire Switzerland magazine.