One of the traps for the unwary investor is buying into markets that have a great story behind them without regard to current trends. One such case is China.
We all know the story: China is growing rapidly as market-opening reforms are allowing its industrious citizens to catch-up with the living standards in the West. With per-capita income still only around one-fifth that of the United States, there’s still a long way to go.
At the same time, China’s population of 1.3 billion is 4.5 times that of America’s. China’s market opportunities are already huge and on current trends are destined to grow much further. Domestically, China is building out its infrastructure to facilitate the conversion of relatively unproductive rural workers into highly productive urban ones. And still reasonably cheap labour costs also mean it remains an export powerhouse and the “workshop to the world”.
Past its peak
Yet you wouldn’t know it by looking at the Chinese stock market. China’s Shanghai Composite Index peaked backed in October 2007 after a furious speculative run-up in the previous two years. Even today, however, stock prices remain 60% below their peak. Last year, prices dropped 21%.
The equity losses are all the more surprising when you consider that the economy has hardly skipped a beat in recent years, and underlying corporate earnings still appear to be growing well.
During the global financial crisis, year-on-year quarterly growth bottomed at 6.5% in early 2009, but had bounced back to 11.9% by year-end. In 2010 and 2011, the economy grew by 9.8% and 8.9% respectively. The economy’s resilient performance has been reflected in earnings growth, with the measure of forward earnings from the MSCI China index growing strongly since the global financial crisis.
As should be evident, the fall in the market, therefore, has largely reflected falling valuations – the price-to-forward earnings ratio for the China MSCI index has slumped from 15 in mid-2009 to only 9.2 by the end of April. That compares with a longer-run average of 13.
Why the concern with China?
The massive stimulus program unleashed during the global financial crisis (GFC) to keep the economy afloat unwittingly helped spark a bubble in property speculation. Chinese policy makers have been trying to reign in lending in the wayward sector ever since – with mixed results. Together with a slowing in exports to the troubled European region, the China pessimists have been vocal in expressing their long-held expectation that the time was ripe for the fast-growing economy to hit a wall.
But China continues to defy expectations. Only this week we learnt that China’s official purchasing managers index for the manufacturing sector inched back up to 53.3 in April – a two year high. Annual economic growth slowed to a still robust 8.1% in the March quarter, and officials are aiming for growth of around 7.5% for the year as a whole.
Digging deeper in China’s property problems, moreover, it appears excess building and inflated prices have been largely concentrated at the top-end of the market and among mainly China’s rich investing elite. These are the type of investors likely to hold their properties for the long-term rather than dump them on the market. More broadly, the process of urbanisation continues to fuel solid underlying demand at the more affordable end of the market.
Finding a bottom
We’re not there yet but China’s stock market is trying to find a bottom. Once policy makers judge the economy has slowed by enough to loosen their tight credit reigns more extensively. It could lead to a major switch in local investor interest from property to stocks. International investors are also poised to re-enter the market given its cheapness, once they’re comfortable that China’s economic landing will be soft rather than hard.
So investors should be on the lookout for a change in trend.
How to buy China
Although there are many ways to invest in the Chinese market, perhaps the cheapest and easiest is through the iShare’s FTSE China 25 listed exchange traded fund (ASX:IZZ). This invests in the largest and most liquid Chinese stocks listed on the Hong Kong market, and charges an annual management fee of only 0.72% for its effort. Being unhedged, it should also gain if the Aussie dollar starts falling.
One word of warning, however, is that this index has relatively high sector concentration: the financials market makes up 53% of the index, while telecommunications and oil and gas companies account for a further 18% and 15% respectively. That said, when sentiment finally turns in favour of China once again, it’s likely to lift all boats.
Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Anyone should, before acting, consider the appropriateness of the information in regards to their objectives, financial situation and needs and, if necessary, seek professional advice.
Also in the Switzer Super Report:
- Peter Switzer: It’s May! Should we sell or stay? [1]
- Alistair Bailey: The Archibald Prize: is it a jackpot for art investors? [2]
- Charlie Aitken: Cyclical stocks are bottoming. Here’s what to buy [3]
- Andrew Bloore: The three most common SMSF trustee breaches [4]