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CEF Insights: China's Market Transition & Long-Term Opportunities

Nicholas Chui, Franklin Templeton


Nicholas Chui

Portfolio Manager

Franklin Templeton

The Chinese equities market struggled in 2022 and 2023, but the consumer market continues to broaden and develop, which presents potential opportunities for medium and long-term investors of Franklin Templeton’s Templeton Dragon Fund (TDF). Gain insight into the current Chinese market landscape, TDF’s strategy, and why the time is now to invest in China, from Portfolio Manager Nicholas Chui.

The Templeton Dragon Fund (TDF) seeks long-term capital appreciation by investing at least 45% of assets in the equity securities of companies whose primary business are conducted in, or whose main offices are in China. This may also include companies whose business is expected to improve from development in China and may include other Asian firms. Learn more here.


Welcome to CEF Insights, your source for closed-end fund information and education, brought to you by the Closed-End Fund Association. Today we are joined by Nicholas Chui, Portfolio Manager with Franklin Templeton. Franklin Templeton manages the Templeton Dragon Fund, ticker TDF. We're happy to have you with us today, Nicholas.

Nicholas Chui:
It's very nice to be here. Thank you.

Nicholas, the Templeton Dragon Fund is a concentrated portfolio of Chinese equities. Can we begin with your thoughts on the core strengths and challenges of the Chinese market?

Nicholas Chui:
Sure. So, if we look at the China market, what it stands for and what it's always stood for, one of the key strengths that hasn't changed is the huge domestic market that it can serve itself. So essentially reasonably self-reliant and a lot of domestic demand to back that up. At the same time, what's been changing over the last few years is the level of innovation that's been going on. And what this really feeds into is the level of service and the quality of the product that has really improved over the last 10, 15 years. And therefore, as a result, if we put all of that together, it's a reasonably self-sufficient market economy that from a financial asset standpoint should be a bit less correlated from the rest of the world, from that standpoint.
Obviously on the flip side with regard to challenges, China's at a crossroads when it comes to geopolitics, but China's not alone, the world is. At the same time, China's become such a large economy that, well from a base effect, it's naturally just a lot more challenging to find areas of growth, but that's obviously our job and that's where it's most exciting. And lastly, from a domestic standpoint, the way it grew and the way it will grow also has to evolve. But that for us is an opportunity as we see these companies, as we see their levels of innovation, I think the change in itself in that dynamic is absolutely exciting.

I mentioned that TDF is a concentrated equity portfolio. What are the key characteristics you look for in a company and how do you work through the broad range of Chinese companies to select positions for the portfolio?

Nicholas Chui:
So as bottom-up stock investors, we focus a lot on the companies themselves. Obviously, the macro is going to be important, but our starting point is usually the companies. And what we are really looking for is as long-term investors a repeatable pattern, some form of trend. We start off with the earnings of the companies and we like to focus on companies that are able to grow earnings on a sustainable basis, some form of repeatability, but this has to be backed by reasonably strong balance sheets as well as cash flows. So, we are able to explain that earnings and explain the repeatability of it. And ultimately as long-term investors, if we've got these couple of ingredients together, usually the case works okay, but ultimately backing these businesses, the elements of these are usually symptomatic of businesses that have good management, reasonably good strategies. And ultimately in the longer term we believe that stock prices in the market rise because of two key reasons.
Number one is re-rating of stocks, and number two is earnings growth. And we are really taking care of the earnings growth bit here with sustainable earnings growth because re-rating who knows, sometimes the market's hot, sometimes the market's not, and it's difficult to bet on that. So ultimately if we then break it down from a sustainable earnings standpoint, it's really just looking at the sources of revenue. Is it product? Is it distribution? Is it pricing power or is it just a very superior quality product that no one has or very few people have? So then if we put all of that together, I think we are able to form a decent good picture. And for China specifically, I think in the last many years we are able to put together a group of companies that we think are able to perform in that way. In the medium to long term.

Many investors use passive index strategies for equity exposure. How important is utilizing an actively managed portfolio for a market like China?

Nicholas Chui:
I'd say that that argument about passive and active is number one, it's ongoing globally, and I think that will continue to be present as investors look at the asset allocation there. Frankly, the reason why passive would make sense for some investors is because the market is quite complex. But for us as active investors, that is our hunting ground. It's essentially because it's so complex, stock picking works and it pays off in the medium to long term. And therefore, if we look at such a broad universe of thousands of companies, China's got one of the deepest markets globally from a number of company standpoint, and it's a reflection of the deep fundamentals of the economy and what really stands for itself and for the world. So that's a very big playground to start with. And being selective is naturally going to be a bit more difficult, being selective, but that said is going to be really, really important.
And therefore, if I look at for instance, the broad index last year in 2023, MSCI All China, one of the issues was the earnings expectations was revised down across the year, the trended down slightly across, but then beneath the hood, if we looked at the different sectors, actually what we saw was a very, very different trend. Some sectors trended down significantly, and it continued to persist trending down across the year, for instance, like real estate. But they had other sectors like communication services, consumer discretionary, where the revisions were up, and the growth was also up. So that meant beat and raises. So, we are at an inflection point in China right now because of the transition away from property. Many investors are naturally very worried about how it used to grow, which was property and what fills those shoes in the future. But we're starting to see signs of what those gaps might be filled by, and the trends are starting to be quite repeatable, but at the surface a lot of these numbers don't show.
And on the surface, a lot of these numbers don't show if you don't do the work. So that's the thing, no one talks about this on the media because everyone's just focused on the headline and that's why the passive instrument would essentially be tagged to from a performance standpoint. But we need to be selective, and we are selective with TDF whereby we are picking our battles and we're picking the areas where we think can continue to grow sustainably. Because, like I mentioned, we think that in the long-term stock prices do well because of earnings are rerating, and we are really just backing on the parts of the market that we think are able to grow their earnings sustainably. So back to your original question, I think active management in China in particular has a significant role to play. And I think that we are just getting started really on this particular journey with this economic transition.

Nicholas, the Chinese market struggled in 2022 and 2023. We have significant geopolitical tensions that potentially impact markets, but the Chinese consumer market is continuing to broaden and develop. Where do you see the Chinese market currently and what is your outlook for the rest of 2024?

Nicholas Chui:
So, the geopolitical landscape globally has changed, and I think it will remain that way for a while to come. And I do have to stress globally because this isn't just about US, China, or China versus another country. It's not bilateral, it's global. If we look at how fraught global relations are, it's really not at a place where it should be. But unfortunately, as investors, we have to be realistic about that, which is why we focus so much on China. And that China for China story is so compelling and so important for us. The Chinese economy in itself on that point is going through a transition and with transitions, given that it's a structural transition rather than a cyclical one takes time. At the same time, it also brings about a lot of fear because the way the markets worked, the way that stock prices rose in the past and the sectors that drove that could materially be different from the drivers of tomorrow.
And we think that's the case, but it doesn't mean that the story's over. In fact, I think this diversifies the economy further and it makes the growth of the entire economy a lot more resilient and sustainable. And so, if we take that apart then the market's really expecting, for instance, not much growth and that's the very interesting part. So, if you looked at 2023, the MSCI All China fell by about almost 12%, just over 11%. And the market derates it by almost 15%. No one gave any credit or talked about the 3% growth. Now 3% is not a big number mind you, but China's in transition and it's still managed to grow earnings by 3% year-on-year end. And this was the first year coming out of COVID as well where the COVID recovery was bumpy, just like any other geography.
Started off strong off the gates but as people started to normalize habits, businesses started to normalize. Obviously that growth takes time to recover. And then if we look at earnings expectations and what they are across different sectors, for some of them it's not excessive. So, I think expectations are not particularly high. At the same time, you've got an economy that's in transition and the global economy is where it is with regard to geopolitics. So, from a market standpoint, I think that's a lot of negativity that's already priced for China as a result. And I think from that standpoint, it makes it quite an interesting time to be invested or at least be looking and doing the research now because companies in general have been punished, good or bad.
And for us, we're just looking for the good companies that can grow earnings sustainably and therefore for the rest of 2024, I think we're going to be in that state for a while because as the economy is in transition, it takes time. But this is essentially, if we're going to look back, we can confidently say, I think this was the time where it was the best time to really be in the market and be prepared for it because you weren't overpaying for good companies. And that's essentially what we're trying to do by companies at the discount. So, I think that's the opportunity, that's 2024 and the rest of 20, 24 and even beyond is going to give us, as we see those fundamentals come through and that's when you get the earnings growth at a high rate and the revaluation, but we are not going to be able to pay them at such cheap prices anymore. That time is now.

Are you finding valuations to be at attractive levels?

Nicholas Chui:
Yes. And that's because the broad market has been punished by all sorts of reasons, be it geopolitics, be it worries about the transition, et cetera. So that derating I talked about was very real, but that's already happened. And then the question is how much more can that market derate? And if we look at the valuations of the market, it's basically near or at the 2011 to 2015 period where the Chinese economy also went through some property related troubles. So, we're really, I think closer to the bottom. And just from an average standpoint, we're clearly at the one standard deviation reach region, if not more. And so, if one were to believe in the earnings growth that will come through for the market at some point, which we do, just by looking at the different companies. And ultimately for us, the economy is the sum of the parts, some of the parts of the different companies, that's how we look at macro as well.
And if there are a good enough number of sectors and companies that we think are able to grow in the future, that means the economy should be able to grow. That's a very simple assumption, but that's the direction of travel. So, then the valuation that we pay up for that quality of growth, if it's repeatable, sustainable, I think it's extremely compelling, particularly if it's not debt fueled, it's backed by strong balance sheets and cash flows. That's important. And again, that reflects how China has to change the way it grows because a lot of these sectors grew in the past at the expense of those cash flows and balance sheets. We don't quite like those. So, putting it together then from a valuation standpoint, that's why we think 2024 is a good time to be looking at these markets, putting some in, because we're probably nearer the floor from a valuation standpoint.

The TDF strategy is very selective. Where are you seeing the best opportunities?

Nicholas Chui:
We like the China for China story because there's a lot of factors that I think we can control when we analyze the market. We don't have to worry as much about exports, geopolitics, and things like that because it just makes it a lot more complex. It's a lot more difficult to price. If we just take care of the domestic economy, the 1.4 billion people and what that market stands for, there's a ton of opportunity in itself to build a portfolio, a concentrated portfolio. And so, we tend to like to keep it simple, we've got five themes that we are particularly excited about in China in the medium to long term. We call those the five S themes, supply chain, sustainability, services, systems, and savings. Supply chain refers to how China used to provide for the world, just factory for the world, but it's a factory for itself at the same time.
And this was only possible because of innovation that's happened over the years. So, the quality of the output has improved dramatically and therefore it's able to serve itself without the need to really rely on too much imported products, machines, et cetera, from the rest of the world, which it used to. So as that level of and quality of output continues to increase, China providing for itself because it's got the entire supply chain in China or most of it in China is a very strong and compelling case. It can weather a lot of geopolitical uncertainties. With regard to sustainability, China is front and center. Most of the sustainability solutions in things like solar, wind, electric vehicles, most of it comes and originates from China. So, the innovation started in China, they've got the raw materials there, the manufacturing is there, they put it together there. It's very difficult to find another market now that comes a close second, and that will definitely persist because China is extremely, extremely focused on things like carbon, net-zero, carbon neutrality, and you see this when the local governments, the companies are all speaking the same language.
So, if I put that together with the supply chain of sustainability, it's an extremely compelling long-term story. With regard to services, we've got 1.4 billion people, so it's a very strong and big market by itself. And as the society evolves, as we've seen globally, and that's the benefit I think for us in TDF is because our teams, we have got teams that look at global emerging markets and beyond as well, and we work with them closely. One of the key trends that's been happening is the move from goods to services globally. We think China's going to face the same patterns and same trends, and it's going to benefit significantly from that. So that just means a huge opportunity for the services sector. With regard to systems, China used to rely a lot of important software and systems, but that's changing rapidly with the levels of innovation that's been going on.
China's put in a lot of R and D research and development dollars into this sector, and a lot of its private led. So, these are companies that really just manage to hire good people and focus their research dollars on the right areas, and they've just come out with domestic solutions that I think will be extremely compelling use cases for different areas like manufacturing, like financial services, and the list goes on. And so that domestication of softwares and systems in China is a huge opportunity. And lastly, savings, with 1.4 billion people. Again, the benefit is you've got a lot of people and China's always had a savings culture. Even today when it's undergoing a bit of a cyclical downturn, people have actually saved more. So, what that means is when things turn and things will turn at some point, people will spend again and it means a lot of opportunity on different areas, consumption, financial services, healthcare, travel, and the list goes on.
Again, it's not debt fueled, and it's just really cash fueled. And that for us is such an important part that again, if we look at the structure of different economies globally, not many economies have that structure inherently, it's a culture and culture we know takes time to build any road and that culture is still extremely strong as we speak. So, the savings component of China is another key component, and I think if we put these together, the five S teams represent what we think are the best opportunities in China going forward in a transition economy, we think the growth in these areas are likely to be sustainable, very domestic, and almost weatherproof in that sense. So, these are areas where we're focusing a lot of our research and capital deployment at the same time.

How is the TDF portfolio currently positioned?

Nicholas Chui:
So, if we look at the Chinese economy and where it is today, we talked about the medium to long-term trends and how excited we are by those. And therefore, I did mention at the same time we are at a juncture where because the markets have been punished in that sense, this is almost an excellent window for us to be doing that research and capital deployment. So, we're from a positioning standpoint, easing into these names. We don't think that's a rush because we also want to see some form of track record of these companies. We are meeting companies who are meeting the management by the quarter as they have results. So, we're trying to assess how they're doing as we make these judgments and therefore, we're building up that position slowly from a positioning standpoint because we are cognizant about where the markets are pricing things, but at the same time, if anything isn't perceived to work, it does sell off quite viciously.
So that's why we are also not going excessive at this point as well. We are operating on a more balanced approach in terms of the sectors that we are exposed to in terms of the risk factors that we're exposed to in terms of when I talk about risk factors it's things like factor exposures like growth, value, we're trying to adopt a bit more of a balanced approach there as well because this is a market where growth is not particularly pronounced. And so anything that's growth related that is a bit too expensive is also quite risky at this juncture, and therefore that's how we're playing the delicate balance at this point with regard to the short-term mechanics as well as the mid to long-term opportunities that we very much love about the market and trying to bridge that essentially because when we're going from destination A to destination B, we don't get to B immediately, and the market certainly doesn't move in that direction immediately as well. So that's the area that we are cognizant about from a positioning standpoint.

Nicholas, how do you see an allocation to a concentrated portfolio of Chinese equities like TDF best positioned in an investor's diversified portfolio?

Nicholas Chui:
So, we believe that China will work on its own rhythm increasingly going forward just because of how large that domestic economy is. So, this is regardless of geopolitics, it's just the nature of the economy and how it's evolving that a lot of the drivers for China's growth will change. They used to come from property, it used to come from exports. These two drivers are changing gradually in particular property, but so are exports as well just because there's a lot of domestic opportunity at home. And if we look at the factories that produce in China, instead of exporting it, they can actually service a lot of that demand domestically. So as the economy starts to work on its own cycle from a correlation standpoint, it's very interesting, it's compelling and it's a source of diversification for asset allocators and investors. At the same time, we are also finding these unique investment opportunities.
We mentioned the five S themes. And these are themes that very few countries and economies globally will have collectively just because the dynamic in China is so different and each country is different, each country has its own bull case. At the same time, from a cyclical recovery and structural angle, China's at a very unique juncture, which is why valuations are where they are. We can see the long-term picture, but in the short-term mercantilist, people are not pricing in the long term. And that's essentially the fear in the market. And that's why if you look at then global asset classes, very few markets are trading at these levels. There's a lot of euphoria in the markets as we speak, whereas in China it's the flip.
But this is effectively why as an investor, particularly a mid to long-term investor, we should be looking at investment opportunities that are mispriced to such a large extent, especially when relative to the rest of the market. So I think this proposes and imposes an extremely compelling investment case for China, both in the short, medium, and long term, but naturally weathering that is going to just require a lot more active management, and that's why we think stock picking is really going to work, and therefore when we're concentrated like we are in TDF, the value proposition for clients is really when we get it right whilst managing that risk, which is why I talked about that gradual build up in position. I think that the story is just going to be absolutely beautiful.

Nicholas, thank you so much for taking the time to join us today.

Nicholas Chui:
Thank you very much. It was great being here.

And we want to thank you for tuning in to another CEF Insights podcast. For more educational content, please visit our website at

Podcast recorded April 2024.

This material is not, and is not intended as investment advice, an indication of trading intent or holdings, or the prediction of investment performance. All fund-specific information is the latest publicly available information. All other information is current as of the date of this presentation. All opinions and forward-looking statements are subject to change at any time.
Franklin Templeton disclaims any responsibility to update such views and/or information. This information is deemed to be from reliable sources; however, Franklin Templeton does not warrant its completeness or accuracy. This presentation is not intended to and does not constitute an offer or solicitation to sell or solicitation of an offer to buy any security, product, investment advice or service, nor shall any security, product, investment advice or service be offered or sold in any jurisdiction in which Franklin Templeton is not licensed to conduct business and/or an offer, solicitation, purchase or sale would be unavailable or unlawful.

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