Guinness Best of China Fund

In June 2020, we refined the philosophy of the Fund so that it would focus on the structural growth opportunities in China. We have identified seven structural growth areas which we think are likely to grow over the medium-to-long-term:

• Rise of the Middle Class
• Sustainability
• Manufacturing Upgrades
• Healthcare
• Cloud Computing & Artificial Intelligence
• Next Gen Consumer
• Financial Services

Within these growth areas, we also apply a set of quantitative filters to identify quality, profitable companies with strong balance sheets. Quality is defined as a return on capital above the cost of capital while a strong balance sheet is defined as debt/equity less than 150%. These filters reduce the universe from an initial 800 companies to around 320 companies, of which we pick 32 to form an equally weighted portfolio.

When picking the stocks that go into the portfolio, we first “clean” the financial statements to reflect reality. We are most interested in regular, persistent earnings and so aim to remove non-recurring items. These include one-off gains and losses, as well as government subsidies. We break down the balance sheet to identify sources of both strength and risk. For example, many Chinese companies invest a portion of their cash into wealth management products (WMPs). If these WMPs are high risk they can potentially be written down, meaning they are worth less than their accounting value. In this case, a company’s cash holdings would be far less than they seem. As a result of cleaning the financial statements, we eventually create an accurate cashflow statement built on our own calculations rather than taking cashflows as defined by management. Here we pay attention to the different types of cashflow, each of which reveal different information. Overall, we are looking for businesses with the ability to redeploy cash at a high rate of return.

The next step is to carry out a series of accounting checks. These checks aim to identify anomalies in the accounts, covering revenue recognition, capitalisation and amortisation, asset valuations, effective tax rates and return on cash and WMP.

If we like the business, trust management and trust the accounts, we move onto valuations. We are not interested in stocks where a valuation derating can offset most, if not all, of the earnings growth. Therefore we look for stocks where we believe earnings growth can offset a potential valuation derating. We primarily do this using two methods: a DCF approach and an earnings approach. In the DCF approach, we use different combinations of revenue growth and margins to assess valuations in each scenario. In the earnings approach, we use different combinations of earnings growth and final multiples to assess upside in each scenario. These two approaches allow us to take into account the effect of rising interest rates on valuations.