Description

Though I am not really a closed end fund afficianado, every year or two I find one that I think represents a reasonable investment opportunity.  I have posted two prior CEF ideas on this forum; BIF back in early 2016 and CET in February of this year. 

My idea today is Morgan Stanley China A Share Fund (CAF). 

There are several legs to my thesis here, but these are the critical ones:

• CAF trades at a sizable discount to NAV (roughly 14-15% right now, but keep in mind that CAF trades in the US and the underlying stocks trade in China, so there is always a time difference between the two).
• Chinese stocks are really out of favor right now, with the two local markets down between 20-25% for the YTD (through 9/14) and down even further from the highs in late January.
• The CAF portfolio is run in a concentrated style, and while I don't know whether the managers of the fund would describe themselves as "value" investors, their performance track record is outstanding relative to their benchmark and particularly so in down markets.  
• I don't personally have the expertise or experience to play the local Chinese markets, which is one of the markets that I think it is really possible for certain investors to gain a real edge.  As a result, while my contrarian instinct tells me it might be an interesting time to initiate or increase exposure to China on this weakness, I am not going to try to do it.  CAF gives me a one-stop shop as a way to get exposure.
• This last one is kind of a bonus element, but the mainland China stock markets are in the process of being included in the big global benchmarks, such as the MSCI Emerging Markets Index.  Prior to 2017, China's weight in this particular index was all comprised of Chinese stocks traded offshore (mostly in Hong Kong), but in early 2018 MSCI announced it would begin to include certain A shares in the index.  I've read some projections that within a few years the China A shares will comprise 12-20% of the MSCI Emerging Market Index vs. essentially 0% today (China's weight was ~28% or so as of August 2018).  If this plays out, I would expect more capital will have to flow into China A shares as global indexed investment vehicles are forced to match the index weightings.  

I mentioned that CAF has a very strong track record.  Take a look at the figures below and you can see what I'm talking about. 

As of 08/31/2018

However, the fund's performance has taken a hit in the YTD period (-11% or so on an NAV basis, -15% or so on an NAV basis) though of course this still represents substantial outperformance.  

I mentioned that I tend to like CEFs that run concentrated portfolios; this is what CAF's portfolio looked like (this is from July 31st).  I don't have any insight into any of these individual names; I just think this is the kind of portfolio structure that you will see when a manager appears to have a true investing edge of some kind.

The link below will provide current pricing and Fund NAV, as well as all the fund information and reports.  

https://www.morganstanley.com/im/en-us/financial-advisor/product-and-performance/closed-end-funds.desktop.html 

Let me now talk about some of the risks and negatives of the idea.  First of all, the total expense ratio is high (about 1.8%) - but if one looks at the track record it is pretty clear to see that CAF has more than justified any premium to China ETF products (which tend to run 70-80bps or so).  My view is that the 14% discount mitigates this even further.  Also, I generally like to see investor communications from the manager that offer some insight into the underlying portfolio names.  That is not the case here; the portfolio commentary is very general and macro-related, so not a lot of insight can be gleaned regarding why the fund holds the specific securities it does, or even how the manager selects them.  

Finally, I have been historically very cautious on China in general (I remember well all the reverse-merger frauds and general sense of lack of shareholder orientation among Chinese management teams from the pre-2008 years).  My own skepticism is one reason why I'd rather play my notion of getting exposure to the China A market via CAF rather than do it myself, given my sense that these managers seem to have done a very good job of defending capital and they are more likely to sniff out fraud or other bad behavior than I would be.  

Of course, the tariff war and the risk of a worsening of U.S.-China relations, impacts to global trade, etc.  Well, these are risks that I can't really quantify, but they definitely explain why the Chinese market is down as much as it is.  I'm more surprised that the U.S. market is hitting all time highs given how past China growth scares (such as early 2016) hit the US market.  My stance on this is that I'm thinking if these things don't get resolved in the near term, the US market may have its own problems.  I am not making CAF a big position, but just enough for an initial foray to play a contrarian intermediate thesis that Chinese markets are already pricing in a lot of damage from the tariffs, whereas the U.S. markets largely are not, and a longer term thesis that China A shares will eventually gain index inclusion to the point that better reflects the size and importance of the Chinese economy relative to the global markets. 

Catalyst

• Some kind of resolution of trade war in a manner that doesn't really harm China but gives U.S. enough to allow Trump to declare victory and move on.
• Valuation discrepancy between US and emerging markets narrows a bit.
• None of the above happens, but CAF itself is able to close the discount in some manner by share buybacks or some other means.
• Longer term, MSCI Emerging Markets and other influential indexes gradually increase exposure to China A share market