Investing in the dragon: Exploring China's deep discounts and investment opportunities

Signs of a potential economic resurgence in China are evident through strategic economic adjustments and policy interventions

Chinese stocks reached their peak in early 2021 and have since experienced a nearly 50 per cent decline, placing them in a bear market. This downturn can be attributed to a real estate debt crisis, diminishing consumer confidence, and China's decelerating economy. Currently, Chinese stocks are among the most affordable globally in relation to their profits. The continuous sell-off in these stocks has resulted in a detachment of prices from underlying fundamentals, further emphasizing China's undervalued position.

Despite the substantial sell-off, there is limited evidence to suggest that policymakers in Beijing are prepared to implement extensive measures beyond the stimulus they have already provided. Efforts are being intensified by China's authorities to stabilize the stock market following the significant downturn. The drastic decrease in valuations since the peak in 2021 positions Chinese stocks as the world's most attractive value proposition.

Multi-Decade Low Valuations

Investing in China offers compelling opportunities primarily due to its significantly discounted valuations. For context, the valuations of the Hang Seng Index (HSI) in 2017 were 14x Price/Earnings, 1.46x Price/Book Value, and 2.07x EV/Sales. Presently, these metrics, as of the current writing, are substantially lower at 8.73x P/E, 0.92x P/B, and 1.13x EV/Sales, reflecting exceptionally low valuations. These valuations are approaching historically low levels and, on certain measures, are the most cost-effective ever when compared to peers in major markets such as India and the US.

P/E Ratio of the HSI Index

Improving Regulatory Landscape - Leaders Want the Economy Back on Track

Following a two-year decline, China's stock markets deter foreign investors due to perceived uncertainties in regulation and politics. This is despite the nation's attractive features, such as a vast consumer base and moderately recovering economic growth. The government's social policies adversely impacted high-tech sectors in 2022, affecting companies like Tencent and Alibaba. However, recent indications suggest a more lenient approach toward the tech sector with the aim of revitalising the economy.

In recent meetings, President Xi Jinping explored potential stimulus measures, emphasizing support for sectors like affordable housing and infrastructure. These efforts may encompass measures like tax relief, reduced fees, and job creation to enhance income and revive the economy, thereby diminishing risks for investments, though lingering uncertainties remain.

Government Stimulus

Authorities have recently intensified their support, sparking optimism that this instance might deviate from the past. The Hang Seng Index has surged by nearly 12 per cent since its lows in late January 2024.

China's top legislative body has unveiled an ambitious growth target of around five per cent, exerting pressure on authorities to implement further stimulus measures to bolster the economy. The plan includes a budget deficit target of three per cent of economic output, down from the revised 3.8 per cent of the previous year. Notably, China has announced the issuance of 1 trillion yuan ($139 billion) in ultra-long special central government bonds this year, signaling a ramp-up in fiscal stimulus for the world's second-largest economy.

Moreover, local governments have been allocated a special bond issuance quota of 3.9 trillion yuan, an increase from the previous year's 3.8 trillion yuan. Additionally, China aims to maintain consumer inflation at three per cent and create over 12 million urban jobs in 2024, with the goal of keeping the jobless rate around 5.5 per cent.

The funds raised through the issuance of special sovereign bonds will be directed towards financing major national strategies and enhancing security capacity in key areas. The People's Bank of China has also announced a reduction in the reserve requirement ratio for banks and hinted at further supportive measures in the pipeline. Anticipated measures to optimize monetary policy transmission include moderate reductions in Medium-Term Lending Facility (MLF) rates and reserve requirement ratios, as well as potential reductions in Loan Prime Rates (LPRs).

Additionally, there are forecasts that the Chinese central bank may consider lowering interest rates to stimulate economic activity and address concerns of an economic slowdown, thereby fostering a more conducive financial environment.

Exploring Investment Paths into China

Foreign investors looking to enter the Chinese market have various avenues to explore. One approach is to invest in shares listed in Shanghai and Shenzhen through trading links with Hong Kong. Since a significant number of stocks trading in Hong Kong represent mainland firms, this option provides a more straightforward investment path.

Another option involves investing in American Depository Receipts (ADRs), which are shares of Chinese firms traded in the US. Major tech companies like Alibaba Group Holding Ltd., Baidu Inc., and JD.com have listed ADRs.

Additionally, investors can consider purchasing exchange-traded funds (ETFs) listed overseas, such as the iShares MSCI China ETF, Invesco China Technology ETF, and KraneShares CSI China Internet ETF. These ETFs offer a diversified exposure to the Chinese market.

Stocks to watch out:

1. Alibaba

Investing in Alibaba (BABA) is an attractive opportunity due to its recent strong financial performance, including an 19 per cent increase in quarterly profit and a 16 per cent rise in revenue to $36 billion in it’s recent third quarter performance . Alibaba operates across diverse segments, ensuring broad market reach and potential for expansion. Despite the China Commerce segment contributing less than half of the total revenue, it accounts for over 100 per cent of the total EBITA, indicating a solid financial foundation. Concerns about slower growth in this sector are mitigated by the exponential growth in Alibaba's other segments, providing avenues for increased profitability. Overlooked non-core segments, constituting over 50 per cent of revenues, show significant improvements in profitability, paving the way for rapid expansion in cash flows. Alibaba trades at just 7.92x the trailing twelve months (TTM) of free cash flow, indicating potential outsized returns and making it a compelling investment opportunity.

2. Tencent

Tencent Holdings, a key player in internet services, appears set for a rebound. As an internet services portal, Tencent offers diverse services, including value-added internet, mobile, and telecom services, along with online advertising. The company holds a strong position in China's gaming industry through platforms like Riot Games, Supercell, and a stake in Epic Games. With a profitable track record since its 2004 IPO, robust double-digit EPS growth is anticipated for fiscal 2023 and FY24. Sales are forecasted to rise by three per cent this year and an additional 12 per cent next year, reaching $94 billion. Trading near its 52-week lows at around $35.1 per share, Tencent offers an attractive risk-to-reward opportunity. For long-term investors, Tencent's solid track record and its current valuation near 52-week lows make it an appealing entry point into one of the world's leading technology companies.

3. Baidu

Baidu, China's leading search provider, has shares trading near their 52-week lows at around $99. Despite this, the company anticipates high double-digit EPS growth over the next two years, with total sales forecasted to rise by six per cent this year and another eight per cent next year. Notably, Baidu's P/E valuation stands at a reasonable 9.5x forward earnings. With a five per cent increase in online marketing revenue in the third quarter, Baidu has been focusing on AI innovation, including self-driving vehicles and generative AI. An endorsement from Samsung featuring Baidu's Ernie Bot in its new Galaxy S24 smartphone series in China further solidifies Baidu's position as a leading Chinese AI player. Given its attractive valuation and strategic moves in AI, Baidu presents a compelling investment opportunity.

ETFs to watch out:

1. KraneSharesCSI China Internet ETF: The fund tracks the CSI Overseas China Internet Index. It invests in a universe of publicly traded China-based companies whose primary business is in the Internet-related sectors providing exposure to the fast-growing and innovative Chinese internet sector, which includes segments such as online retail, social media, gaming, streaming, cloud computing, and artificial intelligence.

2. iShares MSCI China ETF: The ETF seeks to track the performance of the MSCI China Index. The Index is a free float adjusted market cap weighted index designed to measure the performance of equity securities in the top 85% in market cap of Chinese equity markets holding large- and mid-cap companies across various sectors, including financials, technology, consumer staples, and healthcare.

Conclusion

In summary, despite recent challenges and regulatory uncertainties, signs of a potential economic resurgence in China are evident through strategic economic adjustments and policy interventions. The combination of low valuations and robust share buybacks reflects a growing confidence in undervalued assets, possibly reinstating trust among investors. Notably, the compelling aspect lies in China's significant fall from favor among investors, leading to historically low valuations.

With Chinese shares priced at less than 9x times expected earnings, they stand at roughly half the valuation of their U.S. counterparts and are more affordable than equivalent stocks in Japan, Europe, and the UK. This considerable undervaluation, coupled with a promising earnings outlook, positions Chinese stocks attractively, suggesting that a substantial amount of negative sentiment has already been factored into their prices.

Investors in the UAE can potentially take advantage of this opportunity by opening a trading account with Century Financial. Century Financial, the top choice for UAE investors with over 35 years of experience in the region, offers competitive spreads and commissions. This gives you access to Chinese stocks and over 40,000 other stocks in the global financial markets.

Vijay Valecha is the Chief Investment Officer at Century Financial. The views expressed are his own and do not reflect the newspaper's policy.