Why Chinese stocks are so far out of favour

There’s no question that Chinese stocks have been a huge disappointment for investors. Over the past decade, the MSCI China index – the standard benchmark for foreign investors – has delivered a gross total return of 3.9% per year in sterling terms, barely half the already-disappointing return for the MSCI Emerging Markets ex China.

It used to be easy enough to argue that the overall market was poor because of the large number of state-controlled firms with little concern for their minority shareholders, but there were still excellent opportunities in technology or consumer goods. Yet that has been a harder case to make lately, since many of the big private-sector names have been weak over the past five years.

Still, taken at face value the market now looks cheap: the MSCI China trades on ten times forecast earnings. Certainly that reflects the presence of many poor-quality companies, but a valuation this low redeems a lot of sins for investors willing to take the risks.

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Two problems that floored Chinese stocks

And there is no shortage of risks. We can come up with a list of reasons to worry about China in the medium term. There’s demographics: the population is set to age faster than almost any other country. There’s geopolitics – its territorial interests may one day bring it into direct conflict with other powers such as the US, particularly its insistence that Beijing should one day rule Taiwan, regardless of the views of the Taiwanese people. These are real concerns for investors over the next decade.

That said, we can find reasons to be bearish about almost any country and these have little to do with how poorly the economy and the stockmarket have performed over the past few years. Instead, we can put the immediate problems down to two things.

The first is the bursting of the real-estate bubble. Property had become a huge proportion of GDP – about 25% including both direct and indirect demand – and a key source of growth. It had also become wildly over-supplied, over-valued and over-indebted. The biggest problem with the decision to bring it to an end by curbing lending to developers is that the tougher rules came far too late. Policymakers made the same mistake as Western governments in the 2000s of letting a real-estate bubble run for far too long, with the result that tackling the problem became even more painful.

The second is the crushing of “animal spirits” in the economy, through a series of other crackdowns on tech firms, finance and some smaller sectors. As with real estate, there were often solid arguments for the government to intervene. The giant tech firms had taken advantage of limited regulation and state influence (compared to many sectors of the economy) to build dominant positions and to try to extend this as widely as possible. There was a risk of ending up with entrenched monopolies that harmed consumers and smaller businesses.

The problem was that the crackdowns showed all the traits that worry investors most about China: very sudden changes to regulations, no certainty on where the limits would be, a lack of fundamental private property rights and rule of law, and unambiguous signs that private-sector firms would be squeezed in favour of state-owned enterprises, and increasingly co-opted into serving the priorities of the government rather than shareholders.

China's government must do more

No wonder that foreign investors became relentless sellers and talk of China being “uninvestable” was common. The sluggish performance of the A share markets – stocks listed in Shanghai and Shenzhen – showed that domestic investors were becoming increasingly pessimistic as well.

However, last year there were some signs that the government has pivoted and is becoming more pro-growth and even a bit more pro-business. There have been some moves to boost consumption, support the real-estate sector and provide more financing for local governments. This led to a pop in Chinese shares in September, but the gains have not been sustained. Investors feel the government hasn’t done enough to turn around the economy and that it needs to do more, especially in real estate. The widespread consensus is that the property sector is so influential there is no way to get growth going again without stabilising it in the short term. There is also a fair amount of optimism that the government will do more. If it does, China is so unloved there is a lot of potential for markets to rally.

There are three trusts in the China specialist sector. While they share many major holdings, they also feel distinctively different, which is helpful for investors. All trade on similar discounts of 10%-11% at present, so the decision is really down to strategy.

The largest by far is Fidelity China Special Situations (LSE: FCSS) at £1.6 billion in assets, which last year merged with Abrdn China. One would not call this a value fund, but relative to the others it has a tilt to value and to mid-cap and small-cap stocks. It has the best return of the three over most recent periods, despite carrying the most gearing (23% now) in a tough market.

Next, at £225 million, there’s JPMorgan China Growth and Income (LSE: JCGI). This targets an annual dividend of 4% NAV, paid quarterly, but it doesn’t specifically invest for income – the portfolio has a growth tilt. So some of the payout will come from capital, as is increasingly common with higher-yielding trusts.

Lastly, Baillie Gifford China Growth (LSE: BGCG), with £160 million, is focused on growth stocks in sectors such as tech. This is the former Witan Pacific trust, which was turned over to Baillie Gifford with a new single-country focus in October 2020. The timing of this was not ideal given the crackdowns, and it has fallen a long way since (although better than JCGI). However, if the outlook is genuinely changing, its approach could be a beneficiary.

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