Valuations are coming to the fore in China. In recent weeks, there have been patches of indiscriminate selling in Chinese equities that have produced bargains, particularly among companies where growth trajectories remain intact. This week’s Chart Room shows China equities are offering attractive price-to-earnings ratios when compared to their 10-year historical range, as well as global peers including US, Europe, and emerging markets equities more broadly.
When value emerges
For long-term investors, prospects in China are still strong. Sentiment has taken a bigger knock than fundamentals, with concerns being driven less by the substance of proposed regulations across certain industries and more by a lack of communication and explanation. Despite this, many innovative companies are continuing to deliver strong growth and receive active support from the government, and the pipeline of future investments is robust given the evolution of the STAR Board of innovative, growth-led businesses. Newly floated plans for a third onshore exchange in Beijing would further support small and medium sized enterprises.
It’s instructive to look at the recent example of private education, where the economics of certain parts of the sector have been reset by new administrative measures including converting some tutoring services into not-for-profits. A selloff ensued as the measures were announced, but what we have seen is that some education companies have even been trading below their net cash levels, indicating a dislocation in equity prices. Some of these companies will be able to adapt by changing their business models to capture some of the additional income saved by consumers.
Focus on fundamentals
Maintaining an active approach to Chinese equities could help identify opportunities in areas aligned with the direction of policy such as green energy, semiconductors, new infrastructure, electric vehicle supply chains, artificial intelligence and high-end manufacturing. Many businesses will also need to spend more on compliance reporting, particularly those handling data. Understanding specific sector dynamics and finding companies with more sustainable business models or stronger pricing power will help investors identify the winners.
In the offshore market we see some deep value opportunities, while A-shares companies face arguably less regulatory risk and could benefit more from easier fiscal and monetary policy. Over time, we expect that the MSCI China universe will become more balanced around sector weightings - with internet names reducing and industrials and IT increasing, for example.
If we recall events following June 2015, when Chinese equities lost more than a third of their value partly due to the extent of margin financing, today’s valuations are comparable - but markets are healthier with less margin financing and a greater proportion of institutional capital. Despite the policy headwinds buffeting some sectors China’s broader growth story is unbroken, and pockets of value will continue to spread as new opportunities emerge.