As contrarian investors, we believe it often pays to bet against the crowd. Bargains can sometimes be found where there is controversy and when performance has been poor.
China has been the world’s unloved market since 2020, with 2023 marking the fourth consecutive year of losses for the Hang Seng Index. The US, by contrast, is hitting all-time highs.
Figure 1: Since 2020, China has underperformed global markets
Our positioning in China
Contrarianism is built on the premise that we might go where others do not. As at 30 April 2024, the strategy1 held 54% absolute weight to China including a 2.8% non-benchmark position in Swatch (a Swiss-listed discounted proxy-play on Chinese luxury consumption), a relative overweight of +21.2% to our benchmark.2
Valuations are compelling, and many individual stocks trade on single digit price-to-earnings multiples and unusually high dividend yields. Our conviction has grown as short-term uncertainties – while real – have faded in importance relative to the rarity of the long-term opportunity.
In a recent letter to investors, Jonathan Pines, Lead Portfolio Manager, wrote how we have to typically look further afield to find our best ideas in parts of the market where others are not looking. But, given the unrelenting sell-off in Chinese markets and January’s additional 10% capitulation, even the well-known names within our benchmark had been ‘for sale’. Chinese e-commerce leaders Alibaba and JD.com trade on price-to-earnings (P/E) multiples of 8 and 9 times, respectively. Baidu, China’s Google, trades on a P/E multiple of under 5 times core earnings, after adjustments for cash and investments. Late last year, we initiated a position in Tencent (a stock we regrettably haven’t owned for most of our history), a high quality, dominant social entertainment platform which underperformed last year, in line with the China benchmark, despite delivering sequential revenue and earnings growth and its P/E multiple touching 12x P/E at the lower end of its own range. To use our car analogy for price relative to value, we assessed we were getting a high-quality Ferrari at a bargain price.
China rebounds
Whisper it quietly but, despite a sea of negative sentiment, equities in the world’s second-largest economy have held their ground in recent months. The MSCI China Index traded flat for Q1 overall but well off its early-quarter lows, gaining roughly 26% since the end of January and outperforming most developed and emerging markets.
Figure 2: China leads the pack
What changed in China’s macro picture to drive up stock prices?
Perhaps it is the beginning of the unwinding of the negative expectations and relentlessly bearish sentiment that dominated the market earlier this year. The initial rebound may have been triggered by economic data and policy measures which support the ‘less bad’ economic situation. For example:
- A resilient economy which grew faster than expected in the first quarter of 2024 – expanding at an annual pace of 5.3% and beating growth expectations thanks to strong performances in the industrial and services sectors.
- The NBS Manufacturing Purchasing Managers Index – a leading indicator – moving to expansion in March and April.
- Government-mandated purchases of large-cap stocks by state-owned funds to boost the benchmarks.
- China pledging continued support for the economy at April’s Politburo meeting.
- A ramp up in special bond issuance and the newly announced ultra-long dated government bonds.
- New housing policy measures announced to alleviate the property sector drag on the economy and revive the property market:
- Lowering mortgage rates and downpayments for first-time buyers to a record low 15%, lifting home purchase restrictions in major cities.
- Absorbing some of the excess inventory, local government buying unsold homes for social housing, backed by RMB 300bn lending scheme.
- Further easing liquidity squeeze among developers, special projects eligible for commercial funding.
- The State Council’s national ninth article strengthening supervision and risk prevention to promote high-quality development of capital markets.
- The risk of renminbi (RMB) devaluation looks to be averted and, as the US Federal Reserve moves to an easing cycle, the downward pressure on the RMB should diminish.
Whisper it quietly but, despite a sea of negative sentiment, equities in the world's second-largest economy have held their ground in recent months.
A 'head fake' or is this rally sustainable?
Forecasting anything in the short term is a fool’s game. The fundamental bottom of China’s bear market may only come with clear signs of life in the property market. China has been throwing everything at solving its property problem. Intervention by government and regulators is also beginning to provide a backstop for markets. Most notably, the monetary easing and selective fiscal provision put in place from the end of 2023 has started to take effect and there are signs of sequential improvements of macro data. Growth indicators have exceeded expectations in recent months, bolstered by manufacturing activity and a recovery in exports.
The rally in Chinese stocks has gained momentum, with the MSCI China having broken above key technical resistance levels above the 200-day moving average.
Figure 3: Breaking out
Attractive risk/reward
Chinese equities are still trading at depressed multiples, with near-record large discounts relative to their historical averages, and to their emerging and developed market counterparts. Attractive valuations may have more appeal if earnings accelerate as consumer and business confidence recovers and growth conditions improve.
Figure 4: Hang Seng Index price-to-earnings and price-to-book
Shareholder returns provide a floor
A key factor driving China’s comeback story has been the recent increase in shareholder returns through dividends and buybacks, initially at state-owned enterprises (SOEs) but increasingly at privately-owned companies too. Not only do these provide strong valuation support, but they also make a compelling case for equity investment in a rate-cut environment. It’s worth bearing in mind that while other countries are facing inflation, China is witnessing deflation. This makes equities attractive for domestic investors when compared against low interest rates offered by bank accounts and could provide additional future support for the market.
Listed companies have strong balance sheets and cashflow, even more so for our holdings, and the dividend and buyback is sustainable. Companies like Tencent, which currently offers a shareholder return of 2.3%, could return around 5% in 2024 with increased buybacks and a 40% increase in dividend yield. So, even if this isn’t the bottom, we are happy owning our companies given the valuations and shareholder returns which we assess to be sustainable.
After three years in a bear market, few believe in China, and it remains a consensus underweight. Valuations remain attractive. Sustained market moves higher may convince more people to buy and eventually real money will come. Time will tell.
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1 Fund representative of Strategy
2 Benchmark: MSCI AC Asia ex-Japan IMI
