By Jade Fu, Investment Manager at Heartwood Investment Management

 Chinese equity markets saw a sharp sell-off at the end of last week on a mix of profit taking, data disappointments and reports of regulators investigating three high profile brokerage firms. Do these developments change our cautiously optimistic view on China?

Although we expected a modest cyclical pick-up in growth in the fourth quarter and have been disappointed by the lack of it, we believe that the overall tone of data out of China continues to support our view of a managed structural slowdown.

We have long held the view that if China is to achieve the transition towards greater domestic demand the likely impact would be for the economy to slow in certain areas, but also thrive in others.  Data trends over the past few months have provided evidence of this unfolding scenario:  a slowdown in the manufacturing and Industrial sectors on slower growth in fixed-asset investment compared with healthy services and retail sales activity.

Indeed, investors have been gradually accepting of the idea that China is a two-speed economy since the late August/early September sell off. Inevitably, though, it will be a slow and bumpy process and, short term, there will be times when investors will overly focus on ongoing data disappointments in the traditional sectors, such as industry and trade.

What does this mean for markets? China’s equity market is likely to go two steps forward and one step back, resulting in a grinding higher scenario with high volatility. But it is also helpful to consider valuations to assess where we are in the market cycle. The MSCI China Index (offshore) is currently trading at 9.7x trailing price to earnings and at 1.3x price to book, which are between 30 and 40% discount versus their 10-year averages. Return on equity on this Index is also discounted, although it is much less at 15%.

Based on our expectation of a continued slowdown together with a bumpy road to reforms, including tighter financial regulation, we have chosen to invest in China via a prudent active fund – the First State Greater China Growth Fund­ which has very select exposures to the market. Since purchase in October 2011, this fund has delivered a 40% return versus the MSCI China Index at 30% (in sterling terms). Year-to-date performance has also been robust: 0.6% versus- 3.2% for the Index.