The charge has begun.

Photographer: Brent Lewin/Bloomberg

Ignore China's Bears

Matthew A. Winkler is a Bloomberg View columnist. He is the editor-in-chief emeritus of Bloomberg News.
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There's a bull running right past China bears, and it's leading the world's second-largest economy in a transition from resource-based manufacturing to domestic-driven services such as health care, insurance and technology.

Just when the stock market began its summer-long swoon, investors showed growing confidence in the new economy -- and they abandoned their holdings in the old economy. These preferences follow Premier Li Keqiang's directive earlier in the year at the National People's Congress to "strengthen the service sector and strategic emerging industries." 

The difference in valuation between the traditional exporting companies that make up the five-member old-economy index and the technology, finance, retail and health-care firms in the new-economy index (both compiled by Bloomberg) is the greatest since 2009. That was the aftermath of the global financial crisis, when demand for everything made in China collapsed.

Today, as China grapples with slowing growth and its less competitive industries are buffeted by rising labor costs, the widening gap between the performance of new-economy firms and old-economy companies is telling. This amounts to a bet that employment and personal income will gain from the increase in domestic consumption of services.

China's gross domestic product is growing at a rate of 6.9 percent, well below the three-year average of 7.5 percent. That's more than sufficient for sustainable investment, because interest rates are much lower than nominal growth. Firms still have an incentive to borrow and invest, with the one-year borrowing rate reduced to 4.35 percent in October.

The outlook is reflected in the best-performing money manager for the China market: Taipei-based Yuanta New China Fund, which seeks long-term investment gains with stable income. The fund returned 25 percent (dividends and appreciation) so far this year, as the rest of the China market gained 3 percent, according to data compiled by Bloomberg.

Compared to the Shanghai Stock Exchange Composite Index, the Yuanta New China Fund overweights technology and health care and underweights energy and materials.

The fund's recipe for success includes a mix of new-economy companies.

In technology, they include Zhejiang Jingsheng Mechanical & Electrical Company and Yantai Zhenghai Magnetic Material.

In health care, Aier Eye Hospital Group and Lepu Medical Technology. 

In financial services, China Merchants Bank, Shanghai Pudong Development Bank and Ping An Insurance Group.

In retail, the holdings include camping and outdoor firms such as Toread Holding Group.

As the fund bought and held such new-economy interests, it discarded energy stocks such as China Petroleum & Chemical and Beijing Enterprises Holdings.

After the recent rebound, the China market remains relatively cheap compared to the rest of the world. That's because Chinese shares trade at an unprecedented 18 percent discount to the MSCI World Equity Index on the price to earning basis. The discount is the greatest this year. During the past 10 years, investors paid an average 18 percent premium for China. Among health-care shares, investors are paying a 37 percent premium for Chinese stocks relative to U.S. peers, almost half the average premium of 65 percent during the past five years.

Even Chinese technology companies are narrowing the gap. They historically had low profit margins, but are catching up to their U.S. competitors. Chinese tech companies' margins are now closer to Americans' than ever before. The blue and white lines below show the profitability (gross margin) of the information technology companies from the CSI 300 index (Chinese large-cap index) and the same metric for peers from the S&P 500 index.

As Yang Liu, chairman, chief investment officer and fund manager at Hong Kong-based Atlantis Investment Management, told Bloomberg this month, the China market is at the "lowest point of historical valuations." Liu, who has been investing in the China stock market since its inception in the early 1990s, said: "We need to be more selective." Alternative energy and health-care firms are high on her shopping list. That's what China's new economy looks like.

(With assistance from Shin Pei.)

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Matthew Winkler at mwinkler@bloomberg.net

To contact the editor responsible for this story:
Philip Gray at philipgray@bloomberg.net