Why You Should Invest in China

Wall: So I thought we'd start today with the statistics that suggests that China has actually overtaken the U.S. as the largest economy in the world. Does this have an impact on stock markets?

Turnbull: If we're honest, absolutely not. When you're looking at long-term economic data, it's like tracking the path of an oil tanker. It's pretty constant, it's pretty set and it changes very, very slowly. Exactly who is ahead at any one point or another really comes down to how you count it. What's much more important to economic growth and ultimately then to stock market returns is what's driving this economic growth going forward, and that's what I think investor attention should be focused on.

Wall: So, what then are the key drivers of the economy and the stock market going forward?

Turnbull: Sure, I mean the two are slightly separate, but what's going to drive the economy is really three things. You have domestic investment. You have domestic consumption, and you have the boost – the gain, or the takeaway that could come from net exports in any given year.

Now, China's growth has historically been driven very heavily by domestic investment and a lot of that has been funded by credit and the big challenge China faces going forward is to see less reliance on credit and to bring down that rate of domestic investment growth whilst allowing the domestic consumer to continue to realize its untapped potential; hundreds of millions of potential new Chinese consumers coming into the marketplaces and driving China's growth domestically.

And of course, in the fairly positive global economic environment we're seeing and increasingly so in developed markets at the moment, China should also be able to benefit from the increased ability to see its exports being sold more widely around the world. And in time as they're seeing more value added in those exports, we can actually see that contribute more to Chinese growth going forward.

So, if you take the economy side of this in total, you'll see a higher quality, if perhaps a slightly slower level of growth going forward. And in the long term, that should translate into fairly good returns for the stock market, but you do need to be pretty careful within the stock market at where you're looking because the process of bringing down credit growth, bringing down investment growth is one of the many challenges that China faces under this broad banner of reform, and reform will be really positive for some sectors, really negative for others.

And from the highest level point of view, it will be really positive for those sort of companies who tend to be private sector, who tend to be more productive, who tend to be more plugged into the future of what China looks like in terms of selling higher-quality branded products to the Chinese consumer providing the services that the Chinese consumer will increasingly consume. It doesn't look like the big inefficient state-run companies who have enjoyed preferential access to all of their key factor input costs, things like land, labour, water, energy, and most importantly capital. As that playing field levels out, you'll see the smaller private companies, we believe, do better. We'll see the service sector do better.

We'll see the big ugly state-owned industries actually start to struggle a bit more. So it becomes much more a game of alpha, if you will, than beta, investing in China. It becomes much less a case of just tracking where the benchmark goes, but being very specific where you're targeting within the benchmark.

Wall: Looking at that benchmark though, and indeed your fund; although the longtime performance has an upward trajectory, there has been a lot of volatility in the fund and indeed in the stock market, what has caused that? And is that just something we're going to have to learn to accept as investors going forward and be a bit more picky and not go for trackers, go for stock pickers?

Turnbull: I think so. I think that there are two sides to the volatility in China. One is a fairly structural issue, which is the effect of this process of reform. Whilst in the long-term, it's positive for stock market growth, because the economy will be doing better. In the intermediate term, we're talking – looking at the precedents of countries like Taiwan, like Korea, as they went through similar economic transformations, a medium-term of maybe up to three years or so, we could be talking from the benchmark point of view, a pretty rocky ride as it tends to be fairly range bound, supported at the bottom by a government commitment to growth, but capped at the top by a government commitment to reform and I think that remains sort of the benchmark of your long-term outlook.

From a more cyclical point of view, we've seen a lot of volatility, certainly over the last six months or so, because as I mentioned, there really are only a handful of areas that look really exciting within China. Those companies plugged into the future look of China. The thing is, by the end of last year they were pretty widely aimed, and as such they end up being pretty expensive as well.

What we've seen in the last six months is not really a change in fundamentals. It's been a change in sentiment. The boat was too far over to one side and investors have looked to lock in some profits and have seen some incremental positives around reform and have moved back perhaps to find some value in some of the less attractive long-term areas of the market.

I think we will see periods where that does occur. And as fund managers, it's our role to decide whether that is a trend that is going to sustainable enough to warrant paying some respect to or whether to stick solely to your guns, but, I think you'll see there is very cyclical opportunities, but in a long-term structural context of wanting to be again very focused on those new China type stocks.

Wall: So investors should just hold their nerve and not be too obsessed with the sort of short-term volatility?

Turnbull: I think China is a market that produces a huge amount of skepticism, a huge amount of cynicism and that is an inevitable part of the debate of a country which is facing up to big challenges. Now the Chinese leadership thus far, even though indeed the last 30 years have a formidable track record of successfully implementing the appropriate policies, and the strength of leadership under President Xi that we've seen in the last year has exceeded probably anybody's expectations that he's consolidated power pretty successfully and is able to drive forward this reformed agenda. I think that's actually a great cause for optimism for positivity, but yes, I think that will continue to be a point of very hot debate. I remember seeing a cover to economist magazine in about 1999 with a picture of Chinese junk going down a whirlpool. People have been predicting that China was going to blow up basically every year since.

Now, China faces challenges certainly. It has the ability and we believe the strength to face up to those challenges and critically the will power too. However, the challenges they face are not – they're not time unlimited, so I think people will continue to predict the death of China every single year, and I think every single year, they will be frustrated, and I think every single year that will give the patient long-term investor decent entry points.

Wall: Doug, Thank you very much.

Turnbull: Absolute pleasure.

Wall: This is Emma Wall for Morningstar. Thank you for watching.