Is China a value play?

One of the more surprising points made during the emerging markets event we held earlier this year was, as highlighted by Schroder Asia Total Return (ATR) manager Robin Parbrook, the fact that Chinese equities have been by far the biggest beneficiary of foreign fund inflows over the past five years among the countries included in the MSCI AC ex-Japan Index.

More than $200bn flowed into Chinese equities in the five years to end of January 2023. Admittedly this information may now be out of date but it is hard to imagine there having been net outflows that would have offset that amount significantly in the subsequent seven month period.

This is not what you would expect if you looked at funds in Morningstar’s Asia Pacific ex-Japan category today. The average fund in the sector had a 17.1% weighting to China at the end of July, compared to a 29.2% weighting in the MSCI Asia Ex-Japan Index.

Things are a bit more nuanced than that as funds were also overweight to Hong Kong equities, with an average weighting of 8.0%, versus a 5.2% weighting in the index. But despite changes in Hong Kong, such as the cancelling earlier this year of a policy that required Chinese companies to treat their Hong Kong-listed shares as a separate share class, there is still a good argument to be made that investing in Hong Kong is distinct from China and thus not evidence of a manager’s bullishness about the world’s second-largest economy.

And there are lots of reasons not to be optimistic about China’s prospects. Leaving aside political tensions, the country’s population is no longer growing, it has become increasingly expensive to manufacture goods there, the government has cracked down on several industries over the past few years, and there is lots of debt in the housing market.

However, and as annoyingly cliched as it may to be point out, more value-driven investors do have to embrace a level of contrarianism in order for their strategies to work. Given how many investors are now underweight China, the country arguably fits into that framework.

One interesting point on this front is the fact that part of the reason Chinese equities have delivered such poor returns over the past two decades is due to the huge amount of equity issuance they have engaged in.

Research from Gavekal published in May of this year indicates that, from the start of 2007 through to end of 2022, listed Chinese firms averaged $87bn in equity issuance per quarter. This was something Robin also noted in his talk as having been highly dilutive to shareholder returns – indeed it is likely one of the main reasons it would have been a bad idea to be a passive investor in China over the past 20 years.

Will this continue? It is hard to say but a major driver of that fundraising was to fuel investment in capital intensive areas, like building out infrastructure and housing projects. It is hard to see this continuing. For example, China now has one of the highest home ownership rates in the world. According to research published in the Journal of Housing and the Built Environment in 2021, about 90% of Chinese families own homes. This rises to 96% in urban areas.

In contrast, the service economy is very small and growing. As that same piece of Gavekal research noted, if you strip out the service industry, China’s economy is about twice the size of the US’s. In other words, China’s service economy is comparatively small today but has the potential to expand.

It is really this theme that abrdn China (ACIC) is playing into. The trust, which continues to trade at a wide discount despite strong underlying earnings, is focused on several themes, but they broadly fit into the pattern of Chinese people spending more on discretionary goods or upgrading their non-discretionary spending.

As noted, China is arguably a value play today and most metrics reflect that. Indeed, if you look at price to forward earnings as a crude reflection of that, the MSCI China Index is trading at a lowly 10.9. Perhaps it says something about the UK that it is one of the few major regions trading below China today.

This is also one of the reasons the managers of Invesco Asia (IAT) are now overweight to China and, unlike many of their peers, underweight India. Manager Ian Hargreaves and Co-Manager Fiona Yang take a disciplined approach to valuations and avoided a lot of the fallout from the crackdowns on Chinese tech because of this.

However, they now view China as having returned to more attractive valuation levels and are also playing on some of the themes that the ACIC are investing in too. A key area for Ian and Fiona remains technology, which they believe is now unlikely to see further regulatory pressure.

Perhaps counterintuitively given the negative sentiment we see towards China, IAT also delivered positive NAV returns in both 2021 and 2022. That share price returns were negative and deviated markedly from NAV returns is perhaps an indication that some of the pessimism we see around China isn’t necessarily warranted.

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