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China’s growth exceeded expectations in the second quarter, but that doesn’t mean investors should choose Chinese stocks indiscriminately.

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“In China we’re focusing primarily on the information technology and consumer sectors,” says Michael Reynal, chief investment officer and portfolio manager at Sophus Capital in Des Moines, Iowa. The firm sub-advises the Renaissance Emerging Markets Fund.

Tech has been particularly strong, he says, citing giants Tencent and Alibaba. “Earnings growth in that space has been explosive,” with 50% to 60% year-over-year growth in the second quarter. “We’re seeing the stock prices reflecting that,” he says.

In the consumer sector, he focuses on the auto and retail industries. “In both cases, the Chinese economy has shifted decisively into consumer mode, away from exports. And we’re seeing this reflected in the stock market [and] in earnings growth.”

Further, valuations remain relatively attractive.

For example, both China and India are large, growing economies, but “the Chinese stock market is trading at roughly half the multiples of the Indian stock market,” says Reynal.

Even so, there are sectors in China that investors should avoid.

Steel yourself against steel

Reynal avoids lower-growth, regulated sectors, such as telecoms and utilities. Though he concedes that both are fundamentally sound, he says, “Returns are less attractive, and, more importantly, we worry about the regulatory environment.”

He’s also “extremely” underweight the state-owned enterprise sector. In particular, he avoids the older economy space, which he describes as cyclical industries with significant overinvestment during the last couple of decades.

“I’m referring specifically to steel, cement and chemicals,” he says. “In the steel space, in particular, we’ve seen massive overinvestment of steel capacity in China […] to benefit from the growth of the Chinese urban landscape.”

Though construction continues, it’s at a slower pace.

“China needs to [shut down] excess capacity in a number of those older industries — and indeed [it is],” he says.

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So far this year, China eliminated 128 million tonnes of steel production, he notes, which is significant. “These are mostly smaller or inefficient plants […] consolidated into the larger leading players and then shut down.”

He intends to monitor the shift in output of these older industries. While he reiterates that he’s currently underweight the sector, he says, “We’re looking at that space with excitement for the future.”

Growth gets an upgrade

In August, the International Monetary Fund reported it had revised China’s growth to 6.4% from 6% for 2018-2020. For 2017, growth of 6.7% is expected.

“The trajectory is positive,” says Reynal. “The government continues to invest in infrastructure, the consumer remains significantly underpenetrated, and financial penetration [and] financial intermediation remain relatively low.”

He doesn’t buy into hype that China’s economy could suffer in the face of the country’s looming debt.

“The Chinese consumer and most Chinese corporates are not particularly highly levered,” he says. “If anything, they’re under-levered: they do not have as much debt as most of their peers around the world.”

Besides, China’s debt is concentrated in the stated-owned enterprise sector — particularly in the older-economy industries Reynal avoids. “That’s where the danger lies,” he says.

Otherwise, the private sector and consumer in China are healthy. Says Reynal: “They are doing well and will continue to participate in this rapid growth trajectory, which is ongoing.”

Originally published on Advisor.ca
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