Citywire - Fundsmith: We’ve been proved right on ‘Chinese burn’ fears

Investing in China has become the hot topic of the moment for all the wrong reasons as scores of investors see the value of their investments slide and property giant Evergrande teeters on the brink of collapse.



At Fundsmith, we are not surprised at all. The warning signs have been there all along, so why are people only now waking up to the risks investing in China presents?

On paper, China’s liberalisation, subsequent economic growth and transformation of its capital markets have been almost unparalleled, helping to explain investor interest in the country with China accounting for a significant 34% of the MSCI Emerging Markets index. But the risks have been seriously overlooked, misinterpreted and even ignored by investors as they have rushed to take advantage of the so-called China opportunity.

Evergrande certainly puts a spotlight on the whole situation. It is not a business we follow closely, and our investment process precludes us from investing in property developers (or any other value-destructive sectors such as banks, a likely victim of Evergrande’s woes) as Fundsmith does not invest in businesses that require large amounts of debt to generate returns.

Setting aside oversupply and speculation in the housing market, Evergrande is likely to be restructured to benefit what the Chinese Communist party (CCP) deems to be in the interests of the country. It is hard to assess the repercussions, but what we can be sure of is that the CCP is more concerned with the stability of the financial system and economy and will not care if foreign investors lose money. Last week’s crackdown on cryptocurrencies shows that it is not just foreign investors they lack concern for either.

When it comes to China, it’s all about the party and the grip it has could leave investors feeling like they are caught in a long and painful Chinese burn.



Regulatory risks have come to the fore over recent months as the CCP and state-controlled regulators have made several pronouncements that have been particularly unfavourable to foreign investors.

These developments began with the blocking of Ant Financial’s initial public offering (IPO) and have so far moved to cover education, the internet, gaming, property and the Macau casino sector. They have their origins in three spheres – regulatory, political and economic – and suggest the CCP will act to protect its interests, regardless of the impact on those caught in the crossfire.

It became clear to us last year that the Ant Financial IPO was not a one-off regulatory intervention. Ant disintermediated China’s banking system, which does not fit well with a state-directed command economy. When education was targeted by regulators, with tuition firms (a significant sub-section of the market) being told they were to become non-profit entities, the only surprise to us was that private education and communist philosophy had been allowed to coexist for so long. Other areas of intervention include internet content and data-driven industries, which always caused discomfort to the government and where regulators have been trying to exert control.

As our chief executive, Terry Smith (pictured below), has said before: ‘The problem is a lack of real ownership rights. You need to accept that you are in a partnership with the government, and when there is a conflict of interest the interests of the government will prevail.’

Politically, we are seeing more traditional, hard-line communist ideology come to the fore, with a dislike for private monopolies and greater control of the economy and business leaders being matched by an increase in enforced thought leadership and benign paternalism. There is also an increasing cult of personality building around President Xi Jinping, who is likely to seek a further term in office. 

The third driver of regulation is economic. Under the ‘common prosperity’ agenda, there is a desire to keep the costs of housing and education down and improve wealth distribution to prevent discontent. Discontent is, after all, seen as a fundamental threat to the party.

We are often asked why Fundsmith Emerging Equities Trust (FEET) has only 14% of our fund in China, which is significantly below the index. We are also asked, given our views, why we invest in any Chinese stocks. The answer to both is simple. If we invest in any company, whether in China or elsewhere, it has to be a good company on an absolute basis, meaning it must generate high returns on capital, be able to reinvest those returns to support growth, and sustain those returns into the long term.

After rigorously vetting factors such as capital allocation, accounting practices, governance, intellectual property rights, demographics, market structure and regulation, we have found only a very small number of Chinese companies that we deem investable.

Our Chinese investments are in fast-moving consumer goods (FMCG): we own two food manufacturers, one beverage manufacturer and technology, primarily Tencent and NetEase, both of which have been hit in this environment. We see the risks of regulatory interference in the FMCG sector as minimal.

We are well aware, however, that investing in technology in China is almost impossible without doing so by way of a business with a Variable Interest Entity structure, for which there are risks, particularly to those listed in the US. This does not mean that our investments have been without issue or are not at risk of future regulatory actions, but we are not blind to those risks.

Given our long-standing underweight to China, we have been pleased with FEET’s performance, which was strong in 2020 versus its benchmark index and is looking good so far this year, with the fund up 6.6% to the end of August versus 2.3% for the MSCI Emerging & Frontier index.

Michael O’Brien is the portfolio manager of Fundsmith Emerging Equities Trust