Is There Still Investment Value in Chinese Healthcare Companies Amid US-China Decoupling?

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Under the cloud of tense US-China relations, the US has repeatedly introduced legislation targeting Chinese pharmaceutical companies. President Biden signed an executive order urging the reshoring of biotech manufacturing. Additionally, the “Biosafety Act” was introduced to protect American genetic and personal health data, prohibiting US pharmaceutical companies from outsourcing production to Chinese contract manufacturers.

The stock prices of relevant pharmaceutical companies have plummeted, spreading pessimism across the sector.

In such a political environment, do Chinese pharmaceutical stocks still hold investment value?

To answer this question, we can start by examining the potential impacts of the US legislation. First, the president’s executive order on reshoring biotech manufacturing is relatively mild, aiming to regain control over the pharmaceutical supply chain. Companies engaged in manufacturing for US clients might face some risks but could circumvent policy sanctions through supply chain relocations or building factories abroad. The “Biosafety Act,” however, specifically targets pharmaceutical outsourcing companies, including CROs (Contract Research Organizations), CMOs (Contract Manufacturing Organizations), CDMOs (Contract Development and Manufacturing Organizations), and CSOs (Contract Sales Organizations). The Act has named several pharmaceutical companies, with WuXi AppTec being notably impacted, having previously been a favorite among investors.

WuXi AppTec primarily undertakes drug development, testing, and mass production for global pharmaceutical companies. American biotech firms, especially smaller ones, rely on experienced and well-staffed companies like WuXi AppTec for drug development and manufacturing. While WuXi AppTec has generated significant profits for these companies and improved the health conditions of many Americans, its business inevitably involves accessing US public health data and drug patents. Currently, this seems to be an unsolvable issue. Although the Act provisionally allows existing contracts to be extended to 2032, giving WuXi eight years for soft landing, the challenges facing the CXO business amid US-China decoupling appear to lack clear short-term solutions.

As of the end of 2023, there are 26 CXO companies listed on A-shares and H-shares, comprising a small portion of the pharmaceutical sector. The sector also includes many other companies engaged in medical services, medical devices, traditional Chinese medicine, chemical pharmaceuticals, and biotech. These companies, if focused on domestic business, are naturally less affected by US-China conflicts. Even those involved in exports, such as leading medical device companies and innovative biotech companies, may not be as significantly impacted by geopolitical tensions as one might think.

The reason is that top-tier medical device and original biotech companies mainly rely on their own R&D capabilities and innovation to compete internationally, unlike outsourcing companies that depend on foreign orders. The US has little incentive to suppress Chinese innovative drug companies due to the significant gap between the two countries’ strengths in this field. US innovative drug development is highly advanced, with many treatments for cancer and critical illness originating from US patents. Currently, the number of innovative drugs exported by China is minimal. The US government barely has any reason to stifle such a small competitor, especially that China is its major export market for innovative drugs. Even if China’s technological advancement rapidly improves in the coming years, the healthcare industry is fundamentally based on patent protection, which means it’s improbable for the US to deny Chinese innovative drug patents without undermining its own. The pharmaceutical sector accounts for over 17% of US GDP, and dismissing Chinese patents would have unimaginable repercussions for US pharmaceutical companies and the economy.

Therefore, we remain optimistic about domestic innovative drug companies with strong original research capabilities. A recent phenomenon shows Chinese innovative drug companies selling their developmental drugs to small American pharmaceutical firms, acquiring equity in these companies. When large multinational pharmaceutical companies acquire these American firms for their drugs, Chinese innovators benefit from equity transactions. While preclinical drug trading among pharmaceutical companies is common, Chinese-developed drugs in the US market often cost less than similar drugs developed by Japanese and Korean companies. This method helps secure fairer prices for good drugs.

Of course, for pharmaceutical companies, the ideal model is to directly export patented innovative drugs. China’s R&D investment as a percentage of GDP has been soaring through the past years. Against this backdrop, it is promising for Chinese innovative drug companies to play an increasingly important role in the international market.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein. In respect of any discrepancy between the English and Chinese version, the English version shall prevail.

Is the Chinese Market Finally Bottoming Out?

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The Chinese stock market has been hovering at low levels for a long time, with the performance of Hong Kong stocks particularly dismal. The Hang Seng Index fell by 12% in 2021, followed by declines of 13% and 10% in 2022 and 2023, respectively. The bear market in 2021 and 2022 was somewhat expected, but last year, with the economy reopening at the start of the year, investors were generally optimistic. However, the market continued to fall. Whenever positive news seemed to emerge, signalling a turning point, it was followed by another wave of declines, each lower than the last.

At its core, stock investment is a matter of confidence. The main culprit behind the dismal performance of the Chinese market is the lack of investor confidence. Therefore, good news is often ignored, no news is interpreted as bad news, and bad news triggers indiscriminate selling.

Without an increase in confidence, the stock market will struggle to see a meaningful rebound. Fortunately, signs of a bottoming out of confidence seem to have emerged.

Firstly, with concerns about earnings dissipating, market sentiment has significantly improved.

Major earnings estimate downgrade was one of the main causes for the sluggish performance of Chinese stocks last year. The initial enthusiasm surrounding the reopening in early 2023 led to ambitious growth expectations for companies. However, weak economic recovery and subdued demand after the second quarter undermined companies’ profitability, as they had to constantly adjust their business strategies, significantly increasing the difficulty of inventory management and cost control.

Despite initial consensus estimates of mid-teens earnings growth for the MSCI China Index in 2023, this figure was slashed to mid-to-high-single digit by year-end. In fact, the actual growth was even lower than the revised estimate. Yet, as investors had already factored in the worst-case scenario, the realization of tepid results didn’t exacerbate market sentiment. Instead, attention shifted towards prospects of a 2024 economic recovery after the result season.

While aggregated demand may remain weak this year, visibility in the macroeconomic environment has improved compared to 2023, allowing companies to set relatively realistic sales targets in a more certain economic environment, which generally bodes well for earnings growth.

Secondly, recent improvements in some economic data boosted the confidence of many overseas institutions, prompting them to upgrade their forecasts for China’s growth this year. Goldman Sachs raised its 2024 GDP forecast from 4.8% to 5%, while Morgan Stanley also revised up its figure from 4.2% to 4.8%.

In fact, not all economic data were showing improvement, but GDP and consumption indicators significantly exceeded expectations. GDP grew by 5.3% year-on-year in the first quarter. While the real estate sector continued to lag, exports demonstrated strong resilience. Consumer potential is also gradually being unleashed, with 1.19 billion trips taken during this year’s Qingming Festival holiday. More importantly, the average spending per trip increased compared to 2019 levels, marking the first time this data has surpassed pre-pandemic levels since the economic reopening. Considering that short trips have become more popular now, the increase in average spending further indicates an increase in household consumption willingness.

Thirdly, foreign investors are beginning to reconsider China. Due to factors such as the pandemic lockdown, the real estate crisis, and the regulatory crackdown on platform companies, foreign capital has been flowing out of China in recent years. In 2023, while emerging markets overall saw inflows of foreign investment, $82.2 billion worth of Chinese stocks and bonds were sold. However, there are signs of a recent reshaping of foreign investor confidence. We have witnessed a significant increase in the number of foreign investors at recent investment summits. Additionally, last year, when faced with relatively positive company earnings guidance, their initial reaction was skepticism. While it cannot be said that they are fully embracing it now, it is clear that they are searching for reasons to reallocate to China. This change is attributed to extremely low valuations, but also to increased confidence resulting from the improving economic data. Over the past month, the level of buying from our institutional clients has reached a level not seen in the past year. From this perspective, market sentiment seems to be changing.

Overall, the Chinese stock market has experienced too many instances in the past two years where it seemed like dawn was approaching, only to fall back into darkness. Whether this time it will truly recover remains to be seen, and subsequent economic data and external risks need to be closely monitored. However, the momentum of change appears to be approaching a pivotal point.

Disclaimer

This document is based on management forecasts and reflects prevailing conditions and our views as of this date, all of which are accordingly subject to change. In preparing this document, we have relied upon and assumed without independent verification, the accuracy and completeness of all information available from public sources. All opinions or estimates contained in this document are entirely Zeal Asset Management Limited’s judgment as of the date of this document and are subject to change without notice.

Investments involve risks. Past performance is not indicative of future performance. You may lose part or all of your investment. You should not make an investment decision solely based on this information. Each Fund may have different underlying investments and be exposed to a number of different risk, prior to investing, please read the offering documents of the respective funds for details, including risk factors. If you have any queries, please contact your financial advisor and seek professional advice. This material is issued by Zeal Asset Management Limited and has not been reviewed by the Securities and Futures Commission in Hong Kong.

There can be no assurance that any estimates of future performance of any industry, security or security class discussed in this presentation can be achieved. The portfolio may or may not have current investments in the industry, security or security class discussed. Any reference or inference to a specific industry or company listed herein does not constitute a recommendation to buy, sell, or hold securities of such industry or company. Please be advised that any estimates of future performance of any industry, security or security class discussed are subject to change at any time and are current as of the date of this presentation only. Targets are objectives only and should not be construed as providing any assurance or guarantee as to the results that may be realized in the future from investments in any industry, asset or asset class described herein.

In respect of any discrepancy between the English and Chinese version, the English version shall prevail.