Chinese Stocks Just Got Cheaper – Here’s How To Take Advantage

Chinese Stocks Just Got Cheaper – Here’s How To Take Advantage
Milou Beunk

almost 3 years ago4 mins

Mentioned in story

What’s going on here?

After rising almost 30% in 2020, the Chinese stock market (as measured by the key MSCI China Index) has been the worst-performing of all major stock markets in 2021 so far. While flat for the year, the index has tumbled nearly 20% since mid-February – and I wonder whether such a big move means now’s a good chance to add some Chinese stocks to your portfolio.

MSCI China (black) vs. US S&P 500, Stoxx Europe 600, Japan Nikkei, and US Nasdaq
MSCI China (black) vs. US S&P 500, Stoxx Europe 600, Japan Nikkei, and US Nasdaq (Source: Bloomberg)

What does this mean?

The past six weeks’ selloff happened for several reasons, but all four concerns might turn out to be overblown:

1️⃣ Uncertain Chinese growth

China’s economy was the only major one in the world to actually grow last year. While that should be cause for celebration, pessimists now worry the expansion may prove to be unsustainable. Investment bank Morgan Stanley, however, reckons they’re overlooking two key points. Not only should excess household savings drive domestic consumption growth of up to 10% over the next two years, but the Chinese government hasn’t spent as much money on economic aid as the US, Europe, or Japan – meaning less risk of withdrawal symptoms as the country goes cold turkey.

That may explain why Morgan Stanley forecasts economic growth of 9% for China this year, well above the country’s own 6% target. Many others agree: according to Bloomberg data, the average forecast among 75 economists is that the Chinese economy will grow 8.5% in 2021. Outstripping expected global growth of 5.6% should be good for Chinese companies’ earnings – and their share prices.

2️⃣ Rising interest rates

A fear of rising interest rates has caused stocks to shudder around the globe. The returns available from both cash and future bonds look more attractive when investors think interest rates will rise, and share prices fall as they then trim their stock allocations accordingly.

But investment bank Goldman Sachs argues that while higher interest rates would indeed hurt the valuations of Chinese stocks, much of that move has already happened. It estimates that US 10-year bond yields – the key measure for longer-term interest rates – should sit at 1.9% come Christmas. They’re already at 1.7%, however, having risen from below 1% at the start of the year: so China’s stock market should have adjusted almost as much as it’s going to.

The 12-month forward P/E ratio for the MSCI China has fallen off already
The 12-month forward P/E ratio for the MSCI China has fallen off already (Source: Bloomberg)

3️⃣ Increased Chinese regulation

A number of potential rule changes for China’s ecommerce platforms, private education providers, and fintech firms have been announced in recent months. They might not immediately alter the earnings outlooks of companies in these sectors, but they could affect their future competitive positioning – and therefore the valuations investors are willing to ascribe to them.

Goldman Sachs reckons that if regulation intensifies, the stocks involved could see their prices drop by as much as 20%. But the investment bank also thinks it’s unlikely that lawmakers will tighten their grip on some of the most vibrant parts of the Chinese economy to the extent that it damages economic growth prospects. Of all areas, this is the one I think it’s most worth investors keeping a close eye on.

4️⃣ US regulation

Further regulatory threats come from the US. The government there’s passed legislation that lets it delist foreign stocks whose financial audits aren’t reviewable by American authorities, or which are controlled by foreign states

Even if US-listed Chinese company shares are affected, however, many such firms are already opting for secondary listings in Hong Kong to allow uninterrupted overseas investment. Furthemore, the rules are unlikely to lead to any immediate forced delistings of non-compliant stocks: they provide for a three-year transition period.

Why should I care?

If you agree that economic growth looks favorable and valuations look attractive, the next step is deciding which Chinese investments in particular could be worthwhile. You’ll have to read our Pack on How To Profit From China’s Explosive Economic Growth for the full lowdown on the various options out there when it comes to buying Chinese stocks, but suffice to say the easiest is probably purchasing “American Depositary Receipts” (ADRs) – essentially shares of big Chinese companies listed on US markets.

Morgan Stanley, however, recommends investors look at domestically listed Chinese A-shares instead. Popular indexes of these typically consist of more economically sensitive and cheap-looking “value” stocks, as opposed to flashy, fast-growing tech types. While not individually available to retail investors, you can back the 300 biggest Chinese A-shares at one fell swoop via an exchange-traded fund such as the Xtrackers Harvest CSI 300 China A-shares ETF.

Goldman Sachs, for its part, believes buying ADRs is best – but the bank does advise investors to be selective about which stocks to pick. It’s therefore run a screen for Chinese stocks with attractive growth, a favorable in-house analyst view, valuation – as measured by price-to-earnings (P/E) or price/earnings-to-growth (PEG) – below long-term average levels, and a company capitalization of at least $1 billion.

12 stocks currently screen as interesting according to Goldman’s criteria, as seen in the table below. What’s more eight of them already have a secondary Hong Kong listing – Alibaba, JD.com, NetEase, Baidu, New Oriental Education & Technology, Yum China, ZTO Express, and Huazhu – which means they shouldn’t be much affected by any of the US angst mentioned above.

Goldman’s screen of attractive Chinese ADRs
Goldman’s screen of attractive Chinese ADRs (Source: Goldman Sachs)
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