How do you pick stocks in China? Which sectors in the A-share market have the greatest investment potential?

What problems would China's stock market face if the economy contracts?

These are questions Xinhua Finance's Money Journal recently put to the man responsible for Franklin Templeton Investments' fund management business in China, India and Brazil. Stephen H. Dover, Managing Director and International Chief Investment Officer for Franklin Templeton Advisors, the largest listed fund management company in the world, answered our questions frankly.

With global liquidity rising, a lot of stock markets have become overvalued and moved into bear market territory. However, it seems China's A-share market is an exception, entering a bull market instead. What are your views on China's A-share market?

Stephen Dover: China's A-share market is quite special. It has a problem with the split share structure and it is less correlated with global stock markets. Many companies' internal values are not reflected in the stock price. When the reform of the split share structure is completed, China's A-share market will be more closely correlated with the global securities market.

However, I need to clarify the concept that the economy is correlated with the stock market. The structure of the stock market is quite different from the structure of the economy. China's stock market is full of fluctuations and many investors believe frequent buying and selling can make profits. But we are not convinced. We believe wave patterns such as these can only make losses.

Which sectors in the A-share market have the greatest potential for investment?

The most important factor in investment is to fully diversify risk. Our risks are diversified in various sectors and we are more willing to choose the best stock in a particular sector, rather than just the sector as a whole. For example, we consider China's consumer goods industry has very good long-term growth potential, even though an industry's growth potential doesn't always mean it has good investment value, as determined by stock prices. Therefore, we also need to study individual stocks.

How do you choose individual stocks? What kinds of measures do you focus on?

We focus on the price/earnings (P/E) ratio. However, we don't look at the P/E ratio published in the market, but look at our own estimated future P/E ratio. We also look at the return on net assets. Good companies should have good returns on net assets and continuous growth. In addition, we focus on the pricing of listed companies. Many companies just enhance productivity and obtain greater market share instead of improving the quality of the company itself. We also look at management quality and experience as well as its relationship with investors.

It is difficult to value Chinese companies, even though our analysts are highly skilled and are well-informed about the operations of the companies they watch. It is difficult to determine whether a stock price of a domestic listed company is reasonable, mainly because there are problems with the current share structure. A company may have both A shares and B shares, with both shares representing ownership in the same company. Yet the valuations of both shares are different and I think this is the reason China's stock market has not performed as well as those in other countries.

The emerging markets and overseas markets have both had volatile periods. There has been a greater focus on the capital flows of the global market. If the economy contracts, what sorts of problems is China's economy likely to see in the future and what factors will trigger them?

Markets always go up and down. This is the reason that we recommend investing fixed amounts on a regular basis. This can effectively reduce the risk arising from volatility on the market. If you believe China's economy will continue to prosper over the next 15-20 years, you will be a successful investor.

Our global fund has two ways of dealing with the market's prosperity and contraction. The first is timing, which is a method familiar to most investors; however, this is not effective in increasing value. The second is investing funds in particular stocks. When the market is strong, we invest in stocks with high P/E ratios; when the market is poor, we invest in stocks with low P/E ratios. The best method is to invest in high quality companies and watch their long-term performance. If you believe the economy will go upward in the next 15-20 years, you will yield good returns over the long-term, even if you incur occasional losses.

On the whole, the global economy is developing rapidly, which presents enormous opportunities. The world is generating large amounts of wealth and there is huge potential that this will continue for some time. I'm very optimistic. If you begin to invest and hold investments for a long period of time, and find a good fund manager who can avoid the risk of losses, your wealth will accumulate over the long run.

A lot of investors like to move around between various IPO funds. This is not a wise decision as frequent change elevates the risk of loss. Keeping one fund for five years or longer is better for most investors.

Currently interest rates are rising worldwide, including in China, which is not good for bonds. Meanwhile, there are a great number of bond funds issued in China. Do you think it is wise to launch a bond fund at this time?

Increasing interest rates indicates that the economy is recovering, which is not a bad thing. However, diversification is needed in investment. Bonds need to be included in an investment portfolio, because the correlation between bonds and stocks is weak. As we all know, we are in a cycle of rising interest rates. This is reflected in bond prices. For investors, the most basic investment should be fixed-income assets.

Commodity and equity markets have performed well in recent times, with ample funds in the markets. What is Franklin Templeton's next investment strategy?

After 2000, market liquidity increased globally, and central banks in most countries took measures to reduce liquidity. To maximize returns, many are investing in high-return investments, which may produce an economic bubble. The widening interest rate spreads between government bonds in emerging markets and U.S. federal agency bonds is an obvious sign of this.

Over the past five years, some investors investing in emerging markets have enjoyed high returns with relatively low risk, and many as a result believe investing in emerging markets is safe. History has shown that after periods of growth, there will be periods of slowdowns and there are risks in both the stock and bond markets. Products that carry relatively low risks should also be invested in, and high returns should not be expected from these products.

One of the results of rising global market liquidity is that all products are overvalued, with products that carry high risks even more seriously overvalued.

QDII (Qualified Domestic Institutional Investors) is being promoted at present. What kind of products will be launched by Franklin Templeton Sealand Fund Management Co. Ltd., the first enterprise in which you have invested in China?

The QDII products we plan to launch are in the form of funds. What makes them different is that these products will invest in overseas markets directly. We plan to invest in the global equity market with one product—the Flex Cap Fund-and invest in the global fixed-income market with another product—China Income.

The equity investment scope of the Flex Cap Fund is quite broad. It mainly focuses on growth equities and the growth rate of net asset return. The investment targets are mainly medium-to-small market valued equities. To be frank, it will not be the best equity fund; we expect it will be a fund with above-average yields, but one that has a stable performance and carries medium risk.

In the future we plan to issue more aggressive funds and we may issue commodity funds. However, our current customer targets are conservative long-time investors pursuing stable returns and who are adverse to risk.

Better research is needed to find better investment portfolios. However, we do not plan to bear too much risk by investing in a particular investment portfolio. As a result, I do not plan to invest in high-risk companies in the Chinese market. Investing in such companies may bring very high returns, but it may also bring large losses.

Franklin Templeton Sealand Fund Management has launched just two funds, which have dropped behind competitors. What is your view on this?

We do not follow the speed of issuing funds. Our primary target is to make sure we are doing the right thing.

In the United States, there are about 7,000 to 8,000 mutual funds launched each year and there are also several thousand hedge funds. There are two types of funds in the United States, namely open-end funds and closed-end funds. It is the same in the Chinese market, with open-end funds allowing investors to apply for purchases and redeem freely, and closed-end funds requiring investors to transfer funds elsewhere.

Most U.S. funds are open-ended funds and most are not equity funds. For example, most Franklin Templeton funds are fixed-income funds, which invest in government issued bonds. As a result, there is a big difference between the two countries.

As a joint venture fund company, we aim to provide clients with suitable investment products so that they can choose different types of products. If you want to ask how many funds we plan to launch, I think ideally there should be 12. China's market is different from other markets. In other countries, we invest some of our funds at the beginning and attract investors with long-term good performances. In China, we plan to launch two or three funds a year.

Personally I believe the current preference in China is not so healthy for investors. Investors buy into funds without the knowledge of a fund's historical performances. IPOs bring large pressure upon salespersons. IPO sales are very large at the outset with sales falling later. Fund companies are compelled to bring fast-growing performance to investors and acquire high returns in short periods for investors with very high risks.

Chinese investors are not very wealthy, but they are becoming more and more so. According to our experience, the method of long-term wealth accumulation is based around average cost investment (at a regular time and in regular amounts). Frequently, investment returns that carry high risks are exaggerated and we want to promote long-term low-risk wealth accumulation.

(Xinhua Finance)

DISCLAIMER: The information contained herein is based on sources we believe to be reliable, is provided for informational purposes only, and no representation is made that is accurate or complete. This briefing should not be construed as legal, tax, investment, financial or other advice, and is not a recommendation, offer or solicitation to buy or sell any securities whatsoever.