Why Investing in Chinese Equities Could Be Your Next Big Move

CCP's corporate crackdown prioritizes public well-being over economic gains, causing understandable investor doubts. However, misconceptions about China's development should be avoided, especially as some parts of the Chinese equity markets are currently trading at historically low valuations.

Indiscriminate Selling of Chinese Equities From Elevated Levels Amplifies Sentiment Beyond Reality

Ongoing foreign divestment in Chinese stocks in recent years has heavily impacted the market, leading to challenges for even BlackRock, which has faced profitability issues since establishing its presence in the region post-COVID. To comprehend this underperformance, one must revisit the substantial increase in Chinese equity weighting in the MSCI index from 2017 to 2020.

Throughout the years, as China's representation in the MSCI grew, its presence in passive investment instruments like ETFs and Mutual Funds also increased. By 2020, amidst the challenges posed by COVID, China's major corporations underwent a rerating process, benefitting from lenient government policies and business models aligned with the pandemic. Consequently, the index reached historical valuation peaks, marked by numerous Chinese stocks reaching unsustainable earnings ratios that exceeded 60x. Sadly for those investors who entered the market at these inflated prices, they suffered from one of the worst drawdowns in Chinese equities history.

There exists a notable divergence in performance among various Chinese equity indices. The MSCI indices stand out, primarily due to their frequent rebalancing and IPO inclusions, which arguably provides a more accurate representation of the country's economic health. On the contrary, China's domestic indices have experienced significant underperformance. There are factors however that have amplified the negative sentiment beyond its actual state. The Hang Seng Tech Index, for instance, was established at the peak of China's IT stocks and demonstrates a preference for high-growth technology companies. However, these companies have encountered sustained selling pressure amid concerns about inflation and interest rates. The index also omits IPOs, which could have bolstered its performance. Examining the historical constituents of the Shanghai Composite and Shenzhen 300 index over the past 17 years indicates that excluded companies often outperformed those retained, primarily because the excluded ones were major manufacturers with inherently cyclical business models.

Shanghai, China

Innovative Firms Fuelling China's Industry Dominance

The optimism towards China is grounded in several factors. Firstly, the Chinese economy's robust creativity persists, demonstrated by its unexpected ascent (and, in some instances, dominance) of industries such as 5G telecommunications, e-commerce, renewable energy and electric vehicles. Secondly, the government's stance on markets has undergone significant evolution. While stock markets historically favoured entrepreneurs, current measures lean more toward benefiting investors. For instance, the China Securities Regulatory Commission has implemented stringent policies, including restrictions on stock sales if prices fall below IPO levels or dividends are not paid. As evidence, last year's IPO issuances in China amounted to RMB1.5 trillion (over US$200 billion), surpassing the US$10 billion in the U.S., a trend continuing into this year.

CCP's Corporate Crackdown Policies and Implications

The CCP's corporate crackdowns should be viewed from both a macro and cyclical perspective. On a macro level, its decisions prioritise public well-being over economic gains, which has understandably raised doubts and created complexity for investors particularly in the aftermath of the severe disruption of the for-profit education industry. On a cyclical level, the government's decisions stem from the rapid growth of China's select internet companies posing a market concentration dilemma. The government's intervention has been to maintain a competitive and diverse market. While there's always room for policy improvement, investors should interpret the government's actions as balancing economic growth with social considerations, avoiding misconceptions about China's commitment to development.