China’s plummeting stock prices, slowing economic growth and currency volatility have pushed many investors out of the market. Nevertheless, we believe that a discriminating investment strategy toward China and neighboring emerging markets has the potential to yield meaningful long-term gains, especially from growth in China’s middle class.

Stock prices on the Shanghai exchange more than doubled in the 12 months ending in mid-June. Fueling that surge was not so much improving fundamentals but rather outright speculation stoked by government purchases of equities, a mandatory increase in margin lending from brokerages, new rules easing investment from Hong Kong into mainland stocks and government media including the newspaper People’s Daily extolling equity investment as a way to achieve national prosperity. A rally driven by hype instead of earnings growth eventually succumbs to gravity. That’s what happened in July and August, with the Shanghai Composite Index as of Aug. 25 plunging 44% from its mid-June high.

Behind the change in investor sentiment lies deteriorating economics in China. President Xi Jinping speaks of bringing about prosperity with a vision that he calls the “Chinese Dream,” and annual growth in gross domestic product averaging nearly 10% from Jan. 1, 1979, until Dec. 31, 2014, suggests that his goal is not just fantasy. But recent turbulence in the world’s second-largest economy indicates that Xi’s dream may be a bit deferred. Chinese exports in July fell 8.3% compared with the previous year, while imports did not perform much better, declining 8.1%. Then, in mid-August, the People’s Bank of China relaxed controls on the yuan—which has been pegged to the dollar—and allowed a 3% decline in a matter of days. Many economists view the devaluation as an attempt to spur exports and revive growth.

Long-Term Winners

Still, we believe that attractive opportunities for fundamental, bottom-up investing endure in China S and Asia’s other emerging markets, where valuations are more attractive than for equities in the developed world like the U.S. The economies of India and the ASEAN-5 (Indonesia, Malaysia, the Philippines, Thailand and Vietnam) entered the second half of 2015 with robust growth. They should benefit from an appreciating U.S. dollar and loose domestic monetary policy.

We are using third-party managers such as Somerset and Macquarie in an effort to position client portfolios to benefit from the rising middle class across the region. We mitigate risk by ensuring that the managers buy shares of Chinese companies outside mainland exchanges, where speculation is rife.

Here are two companies in our managers’ portfolios that we believe can weather the short-term turbulence and excel long term:

From media to fashion to tourism, South Korean companies have ridden the rise of middle-income Chinese. Korea Kolmar, one of the country’s top original design manufacturers of cosmetics, generated about $390 million in revenues last year. It researches, designs and manufactures cosmetics for clients ranging from top Asian brands like AmorePacific to multinationals like L’Oreal. China’s annual retail cosmetic sales increased more than 20% from Jan. 1, 2008, until Dec. 31, 2014, quickly making the country the world’s No. 2 market at about $30 billion.

Established in 1938, China Taiping is one of the oldest insurance companies in China, offering primarily life and property & casualty insurance. Over the next 20 years, the proportion of China’s population over 60 is projected to climb to 30% from about 9% today. Beijing has mandated growth in the insurance industry, aiming to push up insurance penetration to at least 6% by 2020 from about 3% today. It is offering tax incentives for purchasing private insurance and tax deferrals for annuity products and corporate pension plans. While leveraging the policy shifts, China Taiping has restructured its sales force and streamlined its incentive structure.

We think that by investing in companies like these, clients can benefit from China’s long-term growth while avoiding the froth and macroeconomic downdrafts that currently keep investors awake.

 

Please download The Advisory to read other articles in this issue including:

Shadow Consumption
By Paul Chew, CFA, Head of Investments

Economic recoveries usually feature a surge in consumption as employment and wages rebound. Current U.S. consumption data might instead suggest that many consumers are on the sidelines. But rather than clutching their pocketbooks, consumers are reaching for their smartphones and using digital technology to find bargains online and to share goods, potentially influencing the data.

Europe's Slow Climb
By Mick Dillon, CFA, Portfolio Manager, Global Leaders Strategy; Priyanka Agnihotri, CFA, Equity Research Analyst

Greece’s debt crisis has dominated the headlines in Europe this year but has not halted regional growth or vitality among European companies showing unexpected earnings strength.

Rude Awakening
By Stephen Shutz, CFA, Tax-Exempt Portfolio Manager

As recently as 2012 Puerto Rico was able to sell to investors public-sector bonds despite its bleak fiscal outlook and shrinking economy. The commonwealth’s default last month on a portion of $72 billion in troubled debt spotlights not just an ill-advised investment, but a pitfall in the municipal bond market.

Before Tying the Knot
By Chad Larson, Strategic Advisor

Although the divorce rate has fallen for many years, the emotional and financial costs from a split-up are often very high. Protecting inherited assets from a claim by a family member’s ex-spouse can help limit those losses. Such protection can be a cornerstone for sound estate planning.

The views expressed are those of the authors and Brown Advisory as of the date referenced and are subject to change at any time based on market or other conditions. These views are not intended to be a forecast of future events or a guarantee of future results. Past performance is not a guarantee of future performance. In addition, these views may not be relied upon as investment advice. The information provided in this material should not be considered a recommendation to buy or sell any of the securities mentioned. It should not be assumed that investments in such securities have been or will be profitable. To the extent specific securities are mentioned, they have been selected by the author on an objective basis to illustrate views expressed in the commentary and do not represent all of the securities purchased, sold or recommended for advisory clients or other clients. The information contained herein has been prepared from sources believed reliable but is not guaranteed by us as to its timeliness or accuracy, and is not a complete summary or statement of all available data. This piece is intended solely for our clients and prospective clients and is for informational purposes only. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. The companies written in bold-face are stocks currently held by Brown Advisory strategies. The Shanghai Stock Exchange Composite Index is an index of all stocks (A shares and B shares) that are traded at the Shanghai Stock Exchange. A shares are shares of the renminbi currency that are purchased and traded on the Shanghai and Shenzhen stock exchanges. B shares are owned by foreigners who cannot purchase A-shares due to Chinese government restrictions. One cannot invest directly in an Index. Terms and definitions: Price-Earnings Ratio (P/E Ratio) and Price-to-Book Value Ratio are ratios of the price per share of a company’s stock compared to its per-share earnings and book value, respectively.