4 October 2022
*The Company's comparative index is the MSCI China All Shares index (in sterling terms). Total return information is sourced from Refinitiv, Baillie Gifford and relevant underlying index providers. See disclaimer at end of this announcement.
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Baillie Gifford China Growth Trust is a listed UK company. The value of its shares and any income from them can fall as well as rise and investors may not get back the amount invested. The Company is listed on the London Stock Exchange and is not authorised or regulated by the Financial Conduct Authority. You can find up-to-date performance information about Baillie China Growth Trust at bailliegiffordchinagrowthtrust.com ‡ .
For further information please contact:
Naomi Cherry, Baillie Gifford & Co
Tel: 0131 474 5548
Jonathan Atkins, Four Communications
Tel: 0203 920 0555 or 07872 495396
The following is the unaudited Interim Financial Report for the six months to 31 July 2022 which was approved by the Board on 4 October 2022.
Interim Management Report
Over the six months to 31 July 2022 the weakness in Chinese equities has continued. Positive developments on the regulatory front were swamped by macroeconomic concerns domestically and geopolitical concerns regarding Taiwan.
On the macroeconomic front, Covid lockdowns in a number of the major cities, including Shanghai, resulted in disruption to businesses and to consumers. This exacerbated an already weak economic backdrop. We saw the property market slump and weak manufacturing and consumption numbers. The quarterly meeting of the Politburo disappointed investors by offering little additional support to the economy. This in turn led to concerns resurfacing regarding financial risk to the broader economy. Our view is that these risks are exaggerated for the following reasons:
- Whilst debt to GDP remains elevated, it's important to note that it has stabilised and that the quality of debt has markedly improved. Indeed, the government has done a good job of substantially reducing exposure to the most risky debt within the system1. In addition, funding conditions have improved, and the People's Bank of China (PBOC) continues to provide iron clad liquidity support for the banking system. As such, the risk of a Lehman's style moment in China is very low.
- The property market is weak with sales down 30-40% from their 2020 peak. However, it's important to note that this peak resulted from stimulus provided by the government in 2020 in the wake of Covid. If we compare sales figures to 2018, numbers are down but not drastically so. More importantly, the loan to value ratio is sitting at only c.25%2. Most people are still paying for the majority of their properties out of cash. This contrasts markedly with most other housing booms and busts we've seen in emerging or developed markets where loan to value ratios tend to reach c.90%.
- Some property developers are impaired, but the majority are not, and the system itself is both incredibly large and incredibly fragmented. China Evergrande, one of the largest developers, and one that is facing serious difficulties, represents less than c.2% of total system assets. The next 10 combined do not even add up to 10% of the total.
So whilst China has dropped and is unlikely to achieve its previous target for GDP of 5.5% growth in 2022, the risk of financial instability is low in our view. At the micro level, we'd also note that we have no direct exposure to property developers and very little direct exposure to banks. In the main, the holdings within the Company continue to perform well operationally in line with our original investment theses.
The second factor that has weighed on Chinese equity markets is geopolitical. Here, we saw China respond to Nancy Pelosi's visit to Taiwan with obvious displeasure leading to concerns that the risk of military action has increased. Whilst acknowledging the complexity of the issue and the limitations of our own predictive powers, we would say that we believe the risk of military action remains low.
There are a number of factors that lead us to this view:
- Firstly, we think it's important to remember what China itself has said on Taiwan. Here there has been no significant divergence from its longstanding policy. This was reiterated post Pelosi's visit in a White Paper. This White Paper is significant because it is only the third such White Paper on Taiwan and the first since 2000. In the paper, China reiterated its longstanding policy and preference which is for peaceful reunification. The paper made clear that military action was an absolute last resort. Indeed, this makes sense to us given the incredibly high risks involved. For example, if military action were to occur and the Chinese Communist Party (CCP) fail, it would have devastating consequences for the CCP's legitimacy, for economic growth, and potentially also for China's territorial integrity.
- In addition, and contrary to popular opinion, we'd also note that Xi Jinping has not specified an imminent date by which reunification must occur. Instead, he has loosely linked it to a date that's 25 years away, namely national rejuvenation or 2049. In terms of Xi's personal legacy, we'd note that it appears as closely tied, if not more so, to the success of domestic policies such as Common Prosperity, Made in China 2025, and the China Dream. Indeed, we think it's significant for example that theprincipal contradiction, or the most important problem for the CCP to solve during Xi's reign, isn't anything to do with Taiwan or with foreign policy. Instead, it's overwhelmingly focused on building a domestic growth model that continues to benefit all members of society and actively makes consumers lives better i.e. they want to tackle 'uneven and unbalanced growth' and to deliver 'the people's desire for a better life.' These domestically focused policies would be severely disrupted by an incursion into Taiwan, regardless of the outcome. The global response to Russia's invasion of Ukraine has made this abundantly clear. In the face of crippling economic sanctions, the 'people's desire for a better life' would be set back decades.
- Finally,the work that we have commissioned from our third party research providers suggests that, even if China wanted to act militarily, it could not do so. It does not have the military capability. Indeed, Russia's travails in Ukraine have thrown this into stark relief and the difficulty of an amphibious assault on Taiwan over c.100 miles of water is a multiple of that of a land assault on Ukraine.
On balance, therefore, we continue to think that the likelihood of military action is low. That being said, we do acknowledge that this is a rapidly evolving issu e and one that requires continued monitoring. It goes without saying that if military action were to occur, it would have very serious consequences for Chinese equities.
More positively, we have seen a marked improvement on the regulatory front within China. Over the last six months, significant political capital has built up behind the idea that regulation needs to be better signalled and more transparent. This culminated most recently with Xi Jinping stating that 'normal supervision' of the platform economy will resume and that specific measures to support it will be rolled out. This is a significant positive for the platform companies in which we invest and it was echoed by founders of companies such as Alibaba, Meituan, Tencent and Bilibili, all of whom we met during the period.
Portfolio Positioning and Recent Activity
The portfolio continues to represent a selection of the best and most innovative public and private Chinese growth companies. We continue to upgrade the growth profile of the Company, and to make investments in companies exposed to China's next decade of growth and policy priorities including the green revolution, advanced manufacturing and industrial upgrading. In addition, we have added to a number of platform companies that have been weak despite good operational performance.
In terms of new purchases, we have bought a new holding in Jiangsu Azure. Jiangsu Azure is a leading small battery maker. It mainly sells batteries into the power tools market. The electrification of the power tools market is a strong structural driver for this company. Indeed, we believe its end market can double in 5 years as a result. In addition, Azure also has growth opportunities in similar markets such as vacuum cleaners and e-bikes. Benefiting from China's world-class battery supply chain and with strong technology know-how, Azure has penetrated top clients globally. Indeed, its focus on the small battery market and its willingness to invest has resulted in it taking share from global competitors such as LG and Samsung. We do not believe the growth opportunity and the quality of management is reflected in the current share price and have therefore decided to take a holding.
We have also bought a new holding in a company called Kinlong. This company sells hardware for doors and windows (hinges, guard rails, locks) to the building industry. It sells its products to businesses and has built up a strong reputation for quality amongst its business customers. It is the number 1 player in a number of the segments in which it operates with c.10% share. The growth opportunity is a function of continued growth in end markets, the expansion of its product portfolio, plus continued market share gains. Its products are a small proportion of total cost but are performance critical and therefore price sensitivity is relatively low. This year, however, the company was hit by a rise in raw material prices which it will take time to pass on. The shares were also weak due to concerns regarding the property market which we believe are overblown. In terms of management, this is a founder run company with the founder retaining a c.37% stake and managing the business in a long-term fashion. We believe now is a good time to take advantage of share price weakness and buy a holding in a good quality, long term growth company.
We also made additions to a number of platform companies that had been weak despite good operational performance and an improvement in the regulatory environment. These included Beike and Alibaba.
In terms of funding for the above, we have sold our holding in BGI, a leading gene sequencing and testing company. BGI's main business at time of purchase was its non-invasive prenatal testing (NIPT). This business continues to see strong volume growth, but pricing has been unexpectedly weak. Growth in BGI's core business has therefore undershot our expectations. In addition, we had hoped that BGI would be able to leverage its success in NIPT to expand into other areas such as early-stage cancer detection. Here, operational progress has been weak relative to its competitors. As such, we believe BGI's fundamentals have deteriorated and that this is not reflected in the current share price. As such, we've decided to sell.
We have also sold Yatsen. This was an investment with the potential to deliver very high returns, but around which there was a lot of uncertainty. At time of purchase, the company appeared to have a good chance to become a domestic leader in China's cosmetics industry. Whilst we still believe that domestic companies are better positioned than multinationals to take advantage of changes in brand perception and domestic tastes, Yatsen has not been able to execute as we would have hoped. Its operational performance has been weak leading to lower growth and expected profitability. The US listing was also a concern which added to extra downward pressure on the share price and significantly reduced liquidity. We have therefore decided to move on.
We have also made reductions to stocks such as Netease, a leading gaming company, and Shenzhen Inovance, a leading automation company. Shenzhen Inovance, in particular, delivered exceptional operational and share price performance with revenue, profit and share price growth of 2.5x and 3x respectively over three years. Post a review of the holding, and acknowledging the cyclicality in the business, we have decided to reduce our holding size.
Performance
Over the six months to the end of July 2022, the Company's net asset value fell by approximately 10%. Over the same period, the benchmark fell by approximately 5%. We would hesitate to draw too much from short term numbers and would hope that shareholders judge our investment returns over periods of five years or longer, the same period over which we judge our companies' performance.
In terms of the net asset value, notable positive contributors are largely limited to our domestically listed, A Share holdings. Notable stocks here include Shenzhen Inovance, a leading automation company, Sanhua Intelligent Controls, a heat and ventilation control company and a supplier to Tesla, Estun Automation, a leading robotics company, and LONGi Green Energy, the world's largest solar panel manufacturer and enabler of China's green revolution. Relative performance was also helped by the fact that we did not have any exposure to distressed property developers such as Country Garden.
The negative contributors to performance were largely stock specific. In the period, we wrote down the valuation of ByteDance, the Company's only private holding, by c.15% to reflect the contraction in multiples that we have seen in platform companies more broadly within China. China Merchants Bank (CMB), a leading consumer bank, had a volatile period of performance. The share price slumped post the news that the bank's president was removed and under investigation. We think the market tends to overstate keyman risk in the short term. The bank's long-established management culture is unlikely to alter, and the impact on core operational performance should be limited. Indeed, CMB reported good results over the period despite a challenging macro environment. This is a bank with a strong consumer and wealth management platform and one that has a history of good and profitable lending. As such, we remain happy holders. Sunny Optical was another negative contributor to performance. This is a manufacturer of lenses and modules that go into smartphones and autos. It's currently experiencing a price war in its core smartphone business as a new entrant has entered the market and is trying to take share. We think this increase in competition will not persist as the new entrant is loss making and unable to make an economic return. More positively, we think the growth potential in Sunny's auto business, where it is one of the market leaders in lenses for autos, is vast. The primary driver here is the trend towards increasingly autonomous vehicles. We believe this growth potential is underappreciated and therefore remain happy to hold the stock. Other negative contributors include Yonyou, a provider of enterprise software to large corporates, Shenzhou International, a leading garment supplier to Adidas and Puma, and Tencent, a leading social media and gaming company. All three companies were weak due to covid lockdowns and macro weakness which affected their ability to do business and their clients' propensity to spend. We think this represents a short term blip to all three companies strong operational performance and long term growth.
Outlook
In Baillie Gifford's two decades of investing in China, we have experienced numerous regulatory cycles, significant volatility and, at times, painful periods of adjustment. However, whilst investment in China may prove volatile over a short term time horizon, we continue to believe that a combination of a vast and growing domestic market, significant investment in research and development, and private and public equity markets that are poorly understood and very short term, give long-term growth investors like ourselves a real opportunity to generate returns for our shareholders.