Is there now value in Chinese stocks?

28th August 2013

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The Fidelity China Special Situations investment trust has come to symbolise investors’ wider disillusionment with China. In the last fortnight, the trust announced it had been forced to buy back over thirty million shares, around 5% of the total, since Anthony Bolton announced his retirement as FTAdviser reported. This is perhaps understandable; China/Greater China has been the second worst performing equity sector over three years, only trumped by Global Emerging Markets and without Bolton many feel there are few reasons left to hold the trust.

But if the trust is symbolic of wider sentiment towards China, could this buyback represent the bottom? Has sentiment towards China become so negative that it can only go one way from here? Investment journalist Cherry Reynard reports.

In some ways, China looks like the perfect contrarian trade. It has massively underperformed. The average fund in the sector is up just 2.5% over three years, compared to 46.9% for the average equity income fund (source: Financial Express). Admittedly some of that is attributable to historic over-valuation, but most agree that valuations in Chinese equities now fully reflect the weaker growth outlook for the country.

Ria Nova, product specialist of the Neuberger Berman China Equity fund, says that as a deep value manager, she likes this kind of market and can currently pick up good companies with strong prospects at a significant discount to their true long-term value.

She admits that there are still some pockets of over-valuation in areas such as domestic staples, but the real estate and healthcare sectors are providing good opportunities.

Equally, fund flows into Chinese equities have largely dried up. Sentiment has remained resolutely negative with many suggesting that a banking crisis is imminent. Articles such as this Daily Telegraph articulate the real concerns about China. It says: “Thirteen years on, these bad banks still exist…and continue to hold non-performing loans worth Rmb1.7 trillion (£180bn), according to credit rating agency Moody’s. Largely unknown to the outside world, they are a reminder that China’s banking system remains as prone to boom and bust as any Western economy and perhaps more so.” If investors require ‘blood on the streets’ as Baron Rothschild famously recommended, China has its share of potential crises.

Amid all these problems, however, it is clear that the economic picture is improving. Growth has always been relatively strong compared to developed markets, but until recently growth rates continued to slow. Now, there are increasingly positive signs: Russ Koesterich, BlackRock’s Chief Investment Strategist, says: “Recent data is helping to confirm that the Chinese economy is stabilizing…Last month, Chinese industrial production rose by close to 10% on a year-over-year basis, a significant improvement over the prior month and better than economists had forecasted.”

A similar picture is seen on imports and exports – as the BBC report recently: “Chinese exports rose 5.1% compared with a year earlier while imports gained 10.9%. The rises were large swings from June’s data, which showed exports had fallen 3.1% and imports had dropped 0.7%.” Equally, data on electricity consumption, often seen as a more reliable guide to economic activity than state-constructed GDP numbers, is also improving:  As Proactive Investors Australia reported: “While in the first seven months, power consumption increased 5.7 percent from the same period last year to 2990 terawatt-hours. The growth in July was 4.3 per cent higher than a year earlier and 2.5 per cent more than June.”

However, as history has shown, economic improvement has not necessarily gone hand in hand with stock market performance. Tom Beckett, chief investment officer at Psigma Investment Management says: “Using China as an example, the economy there has grown by circa 8% per annum in the last two years, far outpacing any other major country, but the stock market has fallen 17%, as it was over-valued in 2010/11. On the other hand, the US, which has struggled to achieve a rate above 1.5% in that period, has seen its equity market rise by 51%, primarily because equity valuations were decent two years ago.”

However, here too Koesterich believes that the trend may change, saying that current low expectations for China combined with positive surprises in economic data should help support the markets.

But what of the potential banking crisis? If it materialises, all bets are off for Chinese investors, so how likely is that to happen? In its blog, fixed income specialists TwentyFour Asset Management says there are a number of features that China can rely on to avoid this catastrophe: “China has built up the largest FX reserves in the world, it has a banking sector that is funded largely by domestic deposits and restrictions on investments abroad by Chinese nationals amongst others result in banks having access to huge amounts of funds. Also, we believe that the investment led growth model is becoming history.”

Maarten-Jan Bakkum, senior emerging markets strategist at ING Investment Management is less optimistic: “A couple of quarters of slightly better growth will do little to change the outlook for the coming years. The growth slowdown will continue and the risk of a Chinese banking crisis, with major consequences for the entire emerging world, remains too great to ignore.”

It is not a one-way bet, but it is true that sentiment may now look too negative compared to the reality for China. The risk of a banking crisis still looms, but there is plenty to suggest it may not happen and the potential for problems is largely reflected in stock market valuations. It still feels uncomfortable to invest in China, but a true contrarian would argue that is exactly the right time to buy.

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