Is it Time to Pick Up Chinese Equities?

A flurry of negative economic and geopolitical headlines have battered Chinese equities over the past year, leading to multiple rounds of investor pullbacks and eventual capitulation. Today, global funds are significantly underweight China and valuations appear abysmal. Some Chinese stocks have staged rebounds in recent months, and there is market chatter about the potential for rapid growth reacceleration for many companies. Fresh off a recent trip to the country, I believe headwinds remain and lofty expectations may set the stage for disappointment.

The de-rating appears to have stabilized

Many Chinese stocks have undergone a painful transition from growth to value, with companies turning their focus from investment to cost rationalization. This was exacerbated by technical selling pressure as foreign investors reallocated capital from China to elsewhere in the world. Even domestic Chinese investors moved their capital to other countries such as India and the US. Continuous headlines about new technology export restrictions and tariffs only put further downward pressure on Chinese equity valuations.

However, the de-rating appears to have stabilized. Stocks in several sectors have become so cheap that many investors are no longer selling, creating a floor. The MSCI China Index has a 9x P/E versus the broader MSCI Emerging Markets Index at 12x and the MSCI World Index at 18x.[i] Earlier this year, a major Chinese consumer internet stock traded as low as 7x P/E.[ii] In the US, companies trading at such low multiples typically have excessive leverage and uncertain futures.

Mixed fundamentals

Evaluating macro fundamentals in China is trickier than many seasoned investors realize. Actual earnings of many companies have stabilized. Published forecasts, which tend to be overly optimistic in our opinion, reflect a rapid recovery. Overall GDP growth remains above 5% even though China’s struggling real estate market accounts for roughly a quarter of the country’s GDP. The real estate sector has faced high debt levels among property developers, declining home prices and stringent government regulations aimed at cooling the market.

Meanwhile, manufacturing PMI has mostly been in contraction territory as export restrictions and tariffs, particularly from the US, have affected key industries. Chinese consumers on the other hand have resumed spending post-COVID on travel, education and discretionary goods, although there are whispers of expected salary cuts. In our view, this consumer behavior reflects cautious optimism, but we see potential vulnerabilities in the labor market.

In our view, investing in China today is considerably more complex than the blanket growth story that previously drove the market. Fundamentally, we no longer see a rising tide that will lift all boats.

Investing in the new China

Before COVID, many of the large-cap internet and consumer platforms in China were structural growth stories benefiting from rising consumer purchasing power. Since the government began cracking down on companies that grew too big, newer competitors have been able to gain market share. Many of the established, major companies in the tech and consumer space also face challenges in re-accelerating growth due to regulatory constraints and market saturation.

In China’s new investment environment, companies focused on specific verticals have emerged with strong growth potential because they face less competition from the big platforms. These companies, aligned with regulatory tailwinds such as localization, can benefit from domestic demand, in our view. Within the technology sector, enterprise software and analog semiconductor designers are examples of sub-sectors that we believe are positioned to benefit from localization trends, avoid geopolitical restrictions and have proven moats.

The challenge for many investors is to find companies that not only fit investment themes but also meet fundamental criteria such as growth, valuation and governance. There are more than 5,000 companies listed on domestic Chinese exchanges and over 2,000 companies listed in Hong Kong.[iii] In our view, discovering quality investments in China is even more challenging today due to the hurdles for Western investors to visit China and companies and experts’ reluctance to answer questions outside of face-to-face meetings.

Is it time to invest in Chinese equities? We don’t think so, at least not broadly. We believe investors may have too much hope for a rapid rebound as the country faces a weak macro backdrop and continued regulatory headwinds. In our view, investors should be selective and favor areas with sustainable long-term profitable growth where sentiment and valuation do not reflect unrealistic expectations.

[i] Source: Bloomberg, as of July 2024.

[ii] Source: Bloomberg, as of July 2024. Low reached in January 2024.

[iii] Source: Bloomberg, as of July 2024.

SAIFwacmzgym

Certain information contained herein (the “Information”) is sourced from/copyright of MSCI Inc., MSCI ESG Research LLC, or their affiliates (“MSCI”), or information providers (together the “MSCI Parties”) and may have been used to calculate scores, signals, or other indicators. The Information is for internal use only and may not be reproduced or disseminated in whole or part without prior written permission. The Information may not be used for, nor does it constitute, an offer to buy or sell, or a promotion or recommendation of, any security, financial instrument or product, trading strategy, or index, nor should it be taken as an indication or guarantee of any future performance. Some funds may be based on or linked to MSCI indexes, and MSCI may be compensated based on the fund’s assets under management or other measures. MSCI has established an information barrier between index research and certain Information. None of the Information in and of itself can be used to determine which securities to buy or sell or when to buy or sell them. The Information is provided “as is” and the user assumes the entire risk of any use it may make or permit to be made of the Information. No MSCI Party warrants or guarantees the originality, accuracy and/or completeness of the Information and each expressly disclaims all express or implied warranties. No MSCI Party shall have any liability for any errors or omissions in connection with any Information herein, or any liability for any direct, indirect, special, punitive, consequential or any other damages (including lost profits) even if notified of the possibility of such damages.