Investing in Chinese stocks: Opportunity or mayhem?

The Hang Seng Index, one of the world’s most tracked stock market indices on account of being a basket for Chinese companies, closed at 15,165.59 points on October 25. This is a 15 percent drop on a compounded basis between its lifetime high of 33,154 points that it closed at in January 2018 and now. The woes of technology-led Chinese companies continue even as the world has almost recovered from the COVID pandemic as investors continue to sell. An uncertain future continues to spook investors.

Indian mutual fund schemes focused on Chinese stocks have lost between 26 percent and 43 percent since the beginning of CY22. But some savvy investors see a market opportunity here.

What went wrong?

China, the world’s second largest economy, has topped the list of fastest growing economies in the world for many years. The focus on manufacturing ensured that the economy saw a massive export-led growth. The double-digit expansion that the economy witnessed over decades, however, began tapering off. And when the pandemic brought the world to a standstill and the supply chain disruptions caused by brutal and rolling lockdowns in China made the world look for alternatives, the China-plus-one strategy.

That wasn’t all. Sweeping changes disrupted plans of global companies that had their eye on the Asian giant. This included the scrapping of the Ant Group initial public offer , restricting the time that minors can spend on gaming apps and not allowing edtech companies to profit if they were offering school curriculum. In CY22, while the rest of the world emerged into normality following the pandemic restrictions, China continued with its zero COVID policy, which weighed heavily on its economy. Moreover, President Xi Jinping earlier this month was re-elected to power for a third term and appointed his allies in key positions of power. This is considered as further strengthening of government control over the economy and companies operating in China.

“Despite a sell-off in stocks, investors and fund managers in Chinese stocks have got cold feet. They are not willing to buy aggressively due to uncertainty around the policy framework,” said a fund manager with a large multinational fund house, who spoke on condition of anonymity.

Investors are seen selling their stocks and the selloff has intensified of late. Overseas investors sold a record net 17.9 billion yuan ($2.5 billion) of mainland shares via trading links with Hong Kong on October 25, according to Bloomberg data, tipping the year-to-date level into a small net outflow.

Roopali Prabhu, chief investment officer, Sanctum Wealth, said, “Chinese policies indicate that the regime is leaning more towards a leftist ideology. There is no clarity whether the regime will support capitalism or free-market forces to the extent they have done in the past.”

What can change?

Going forward, there is an expectation that the Chinese government may go back to the old-school economic management. It may choose consumption-driven growth over the manufacturing- and export-driven one. The economy is also expected to slow, with analysts saying that the projected 5.5 percent growth appears difficult to achieve for the current year.

While the world is busy raising interest rates to contain inflation at the cost of hurting growth, China is trying to stimulate the economy. The People’s Bank of China gradually cut the one-year loan prime rate to 3.65 percent in August 2022 against to 3.85 in CY21.

But in the midst of this doomsday-like outlook, there are a few who see a chance to cash in. Niranjan Awasthi, head, product, marketing and digital business, Edelweiss Asset Management, finds the current valuations attractive in the context of long-term opportunity in Chinese stocks. “By 2030, it is going to add half a billion people in the middle class. The per capita income is expected to touch $16,000, compared to $9,000 in CY20. This is expected to change the Chinese economy from an export-focused growth engine to a domestic consumption-focused economy, which ultimately should result in sustainable growth in the next five years,” he says.

Though this indicates some upside in medium to long term, the worried lot points to the possibility of further worsening of the situation, which is cramping prices and the valuations.

What should you do?

Compared to 28,543 points on January 2, 2020—just as COVID-19 had started to spread—the Hang Seng closed at 15,165 points on October 25, 2022, a loss of 46 percent. The price to earnings multiple, a measure of valuation, has come down to 5.6 times from 16 times over the same period.

The prices of stocks in China have come down for reasons which may not be temporary. Investors are worried more because of fears of further changes in government policies limiting profit pools available for companies and their ability to share it with minority shareholders.

Shyam Sekhar, chief ideator, ithought Advisory, said, “Though Chinese stocks are quoting at an attractive valuation, there is no clarity on corporate governance of the companies and if shareholders’ rights will be protected by the government. If investors can access high-quality tech businesses along with corporate governance and transparency in the US, then it is better to be invested in American companies.” Sekhar has long believed in concentrating on the US economy as he feels that the bandwidth to track multiple international markets is limited. He says tracking the US market is relatively simpler because there is ample information about US-listed companies.

Analysts say investors need to look beyond cheap stocks. Looking at the decades of high economic growth in the past, they should not enter the market blindly but need to factor in slowing economic growth and changes in government policies, the effects of which on companies’ earnings are yet to be ascertained.

“Though the valuations are attractive, there is limited understanding of how things are changing on the ground. We need to know what we are paying for. It is better to wait till clarity emerges on the policy framework, though it may mean paying a bit more for the same set of stocks,” said Prabhu.

Existing investors in mutual fund schemes investing in Chinese stocks may get a better exit in short term if they are looking for a tactical exit. But without transparency on policy, it does not make a long-term investment option at this moment of time, she said.

For Sekhar, putting money in China at this moment is a risk worth avoiding. “An individual investor may want to invest in China at this moment, but that is a high-risk call and nothing short of sheer speculation,” he said.

The optimists have their own reasons. “I would like to buy Chinese stocks at these prices in my personal capacity. It is a large economy. You need companies to produce goods and services, especially when you are talking of consumption-led economic growth,” said the fund manager quoted earlier.

Awasthi recommends investors look at this only with a long-term view if they are prepared to stomach bouts of volatility. “Like any other country, geopolitical risks cannot be done away with,” he added.

Most investors are better off staying away from Chinese stocks and mutual fund schemes that are investing in stocks listed in China for the time being. Even if you are keen to invest, consider staggered allocation within the asset allocation that suits your financial goals.