Is China Still a Worthy Destination for Your Investment?

Investors in Chinese equity markets have had a pretty torrid time; is China on the backfoot and ready to steam ahead once again?

Cherry Reynard 2 July, 2013 | 9:00AM
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Towards the end of June, the Shanghai Composite sank 5.3% in just one day, to fall below the benchmark 2,000 level. It was its lowest closing level since the depths of the global financial crisis and capped a lengthy weak run for Chinese equity markets. Yet, as he announced his retirement earlier in the month, Anthony Bolton, manager of the Fidelity China Special Situations trust (FCSS) revealed that he had a 'very material' holding—the largest he has ever held in a Fidelity fund—in the trust, believing that the Chinese markets still offer significant opportunities. What is the real situation for beleaguered investors in China?

China has undoubtedly been a difficult area in which to invest. It is the worst performing of all the geographic regions, with the average fund in the Morningstar China Equity category up just 0.16% over three years. Performance looks even worse when the two top performers—the Invesco Perpetual Hong Kong & China and First State China Growth funds (rated Gold)—are stripped out. Bolton himself has been a high profile victim of torrid Chinese markets.

The reasons for the weakness are myriad: First, there was an over-valuation problem. Simon Edelsten, manager of the Artemis Global Select fund, says: "The Shanghai market fell as much as most other global markets in 2008. In our view this was due to over-exuberant ratings in 2007, with banks on 5x book value." He points to stocks such as the Bank of Communication, which reached 4.5x book value in 2007, and now trades on just 1x. Matthew Vaight, manager of the M&G Global Emerging Markets fund (rated Bronze) says that at its peak in 2007, the Chinese stock market was implying growth of 28% per year.

The other problem for China has been the persistent fears of a 'hard landing'. Growth has unquestionably slowed thanks to a combination of weaker exports and poor capital discipline. This means economic growth figures continue to be revised lower. Keith Wade, chief economist at Schroders, says: "We have downgraded our growth outlook for China to 7.8% from 8.2% in 2013, due to a softening of recent data. First quarter GDP surprised the market on the downside, coming in at 7.7% year-on-year as opposed to an expected 8%, with much of this weakness coming in the March data. The recently received data from April reveals a mixed picture, with improving exports but weakness in industrial production and fixed investment."

However, perhaps more importantly, the strong economic growth in China has not necessarily translated into stock market performance. After all, growth of 7-8% should still provide a benign backdrop for company earnings. Vaight believes that the Chinese stock market has been consistently held back by high state ownership and the resulting poor allocation of capital.

From here, investors have a dilemma: It is still possible to construct a relatively bearish picture for China. Edelsten points out that capital does not move freely and the economy is prone to areas of oversupply and scarcity. Equally, its demographics are poor, with the toxic combination of an ageing population and one-child policy giving the country a rising dependency ratio.

The recent sell-off in the Chinese equity markets was prompted by a spike in the interbank lending rate. This is thought to be part of a stand-off between the country's commercial lenders and the central bank with the latter trying to get the shadow finance system under control. Equally, there are still worries over lending practices across China. The long-term transition from a manufacturing-led to a consumer-led economy is unlikely to be smooth, and slower growth and weaker demand may be consequences in the short-term.

However, Chinese equities now have valuation on their side. Edelsten says that he believes the market may now be overpricing the growth of the ASEAN markets and taking too gloomy a view of investing in China. Didier Rabattu, head of global equities at Lombard Odier, says: "We have recently increased our allocation to China since equities are starting to look good value again." He believes that the growth in domestic consumption is a multi-year, even a multi-decade trend and has therefore begun increasing exposure to areas such as beer companies.

Vaight says that he is looking more closely at China than he has done for some time, as valuations now suggest that the risk may be worth taking. Edelsten also believes that the country offers more opportunities than it has for some time. Some commentators are even talking about 'capitulation', a potential sign that markets are bottoming-out.

Patrick Connolly, certified financial planner at Chase de Vere, concludes that there is 'huge investment potential' in China, despite a slowdown in economic growth. However, that growth will be accompanied by significant volatility and investors may be better off accessing it through a broad-based emerging markets fund because, while China may be nearing its nadir, predicting the tipping point may be very difficult. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
Artemis Global Select R Acc1.59 GBP-0.90Rating
Fidelity China Special Ord304.51 GBP-0.49Rating
FSSA China Growth I USD Acc235.50 USD-0.20Rating
FSSA Greater China Growth A GBP Acc12.23 GBP-0.18Rating
Invesco China Equity Fund UK Acc775.42 GBP-0.08Rating
M&G Global Emerging Markets GBP A Acc331.40 GBP-0.19Rating

About Author

Cherry Reynard

Cherry Reynard  is a financial journalist writing for Morningstar.co.uk.