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Consumer staples and services, health care, software and auto stocks are Henderson Global Investors' top Chinese stock picks for 2016 — but don't get your hopes up for a hearty dividend.
Charlie Awdry, China portfolio manager at the asset management company, told CNBC Wednesday that investors should take a discriminating approach to investing in the benchmark Shanghai Composite, the Hong Kong Hang Seng or U.S.-listed American Deposit Receipts (ADRs) for Chinese stocks. (ADRs are issued by U.S. banks and allow investors to buy shares in foreign companies and receive dividends and capital gains in U.S. dollars.)
"I think your broad strategy in China, whether you are in Shanghai, Hong Kong, or U.S.-listed ADRs is that you want to be in cash-generating companies. You don't want companies with debt; you want companies with high margins and decent management. That kind of leads you towards software, where it is of reasonable value; it also leads you to consumer services and also to health care stocks as well," Awdry said.
The Shanghai Composite is on track to post gains of more than 10 percent this year. That's despite a spectacular end to the Chinese stock market bubble over the summer that exported volatility across the globe.
Concerns linger about the state of the Chinese economy and the ruling party's propensity to intervene in financial markets. The country's gross domestic product (GDP) is seen growing 6.8 percent this year and 6.3 percent next by the International Monetary Fund, down from a recent peak of 10.7 percent in 2010.
With that in mind, Henderson's Awdry said it remained downbeat on the Chinese economy going into 2016, but upbeat on the stocks it owned.
Awdry's recommendations include the auto sector, which has felt the heat from slowing consumer demand growth in China.
Automobile sales reached 21,786,600 units in China in the first 11 months of the year, according to the China Association of Automobile Manufacturers. This lagged the number of autos produced — 21,823,900 — and was up 3.3 percent year-on-year.
Awdry described the auto space as "one manufacturing sector in China doing relatively well."
Auto and consumer discretionary stock listed on the Shanghai Composite have gained over 80 percent this year, according to spread-betting company IG.
Industrial profits in China declined 1.9 percent in the first 11 months of 2015, year-on-year, according to the National Bureau of Statistics of China.
Historically, Chinese companies have not returned much cash to shareholders. Awdry told CNBC on Wednesday that there was a "very small shift" by companies towards paying higher dividends.
"That is driven by the pension funds in China that want more dividends, so it is part of the reform of the pension system; they are trying to get their SOEs (state-owned enterprises) to pay out more cash. But I think that it is a very low starting point," he said.
"I think a lot of the yield comes from the fact that valuations are pretty low and for those investors who play China through Hong Kong, which is what most foreigners do, a lot of the dividend yield comes through banks and they pay a reasonably hefty dividend yield once a year."
He advised, however, against investing in Chinese banks.
"I think 2016 will be the first year where we really see whether they get their dirty laundry out, cut profit numbers and cut the dividend. We don't currently own Chinese banks. I'm pretty cynical about that, but I think (they are) a controversial source of yield in the Chinese market," Awdry said.
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