After a slide in Chinese stocks, where to look for bargains

  • By Reshma Kapadia,
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This Halloween, it’s not a Hollywood monster that’s bringing the fright to investors: It’s a whole cast of scary characters, including trade tensions, tech disappointments, rising interest rates, and wild swings in China’s markets. Combined, they helped push the benchmark S&P 500 (.SPX) into the red for the year. Globally, stocks extended their monthlong slide.

Until this week, the U.S. market has shaken off troubles abroad. But like the foreshadowing in a horror movie, there had been signs earlier that China could spook global markets. Chinese stocks have been on a steady decline for months, down 27% since their January high. China’s economy grew at 6.5% in third quarter, the slowest since 2009. There’s a trade war with the U.S., and regulatory, monetary, and economic challenges at home.

And like the intrepid heroes of a horror film, some investors are wondering if now may be the time to tiptoe in. But as any moviegoer knows, there’s usually at least one more scare before the path to safety is clear.

This year’s rout has eliminated $3 trillion of market value, bringing the Shanghai Composite Index down to 2008 levels and ranking it among the worst-performing markets this year. The trade feud is only part of the problem. China has been engaged in a balancing act, trying to eliminate its shadow banking system and shift from an export-oriented economy to a consumer-oriented economy, all without slowing overall economic growth. That act has gotten tougher as rising U.S interest rates and a stronger dollar give China less flexibility to offset the pain from external shocks—like a trade war.

That is raising concerns that China could be in for a repeat of 2015 and 2016, when an economic slowdown, currency devaluation, and policy missteps contributed to a $5 trillion market rout that rattled global markets.

Large U.S. companies like Caterpillar (CAT) and 3M (MMM) have already cited the impact of U.S.-China trade tensions on their businesses. Such earnings reports have served as reminders to investors that China’s problems can quickly become the world’s problems. After all, China is the world’s third-largest importer, integral to all manner of manufacturing supply chains, and the biggest consumer of autos, copper, and iron ore.

China now sits high on a long list of concerns that investors are beginning to process, including the impact of rising U.S. interest rates.

The U.S. may be just digesting these challenges. But China has been wrestling with them for much of the year, to mixed effect. Beijing has pursued several reform efforts, such as regulating companies in the hottest areas of the market. For instance, it has proposed restrictions around the content of new online games and has begun to regulate education companies—moves that have rattled investors and kept companies from spending. China’s efforts to clean up its shadow banking, meanwhile, has meant that consumers, many of whom relied on these alternate sources of credit, are spending less: Auto sales in September fell nearly 12%.

That’s where the potential opportunities come into focus. The government’s efforts have pushed stocks down to attractive valuations. The MSCI China index is trading at 9.4 times next year’s earnings—a valuation last seen in 2016. Earnings in China, meanwhile, are still expected to grow 15% next year. And Beijing is beginning to back off some of the reforms to ease pressure on the economy, whereas U.S. stocks are still near peak valuations and may have much further to fall.

So is it time to invest more in China? The answer is a resounding maybe.

The risks facing China’s economy and markets suggest the market could stay bumpy, mitigating any urgency that investors may feel. Believers in China’s long-term outlook could take some cautious steps, however.

Bargain-hunting is more complicated than just buying a broad index fund because returns could be uneven. Companies caught up in China’s regulatory push or the trade tug-of-war will continue to face pressure; companies that are heavily indebted or lack a strong competitive moat could suffer more under a slowing economy. Still, some active managers are beginning to get a bit more interested.

“The risks are real—globally,” says Rajiv Jain, veteran global investor and head of GQG Partners, which oversees $16 billion in assets. Jain has been reducing his U.S. holdings and incrementally adding emerging markets and European stock. “We are not piling into China in a big way, but valuations are very attractive, and the stimulus should bring a floor. You can’t underestimate policy makers’ willingness and ability to calm people.”

First, the risks. China’s stimulus measures remain a wild card. Beijing has eased monetary conditions and increased lending, proposed income tax cuts, and may offer a rebate that covers a value-added tax, but it hasn’t helped much yet. Policy makers have been taking a more measured approach, aimed at stimulating consumer spending, rather than the old approach of a big stimulus package that pumped money into infrastructure and fueled a debt binge—and that’s a good thing. It also makes things harder.

“Investors don’t have the signal to buy like [they did] in the past from stimulus. Plus, a more focused and nuanced policy is harder for policy makers to execute,” says Andrew Mattock, a fund manager at regional specialists Matthews Asia. “One red flag would be if this approach doesn’t change sentiment, and they need to step in more aggressively and go back to their old ways.”

Indeed, in a note this week, permabear Société Générale strategist Albert Edwards warned clients that investors may be putting the same type of misguided overconfidence in Chinese policy makers’ ability to control events as they did in Federal Reserve Chairman Alan Greenspan’s abilities after he navigated the dot-com bust.

Other risks loom. Some 10% of mainland Chinese shares, also known as A shares, are used as collateral for loans—a possible danger as the economy slows. Some of the risk is factored into the A-shares prices, which are denominated in renminbi, and regulators have created a fund to support companies at risk. Any negative news, however, could create another wave of selling. The upside, Jain says: Margin-oriented selling tends to be swift rather than a prolonged exodus of investment.

Money managers surveying China are largely avoiding debt-laden stocks, including those listed in the domestic A-shares market, instead favoring high-quality companies that generate plenty of cash flow and possess strong brands and competitive positions that can help them weather slowing growth. That includes Chinese companies geared toward consumers, which should get some help from stimulus, such as casual-restaurant operator Yum China Holdings (YUMC).

Also of interest: companies like Ping An Insurance (PIAIF) that should be hurt less by new regulations than smaller rivals. Battered companies in areas like water treatment and waste disposal, like Beijing Enterprises Water Group (BJWTF), are aligned with China’s priorities in targeting its environment and could rebound. While managers still like Internet giants Alibaba Group Holding (BABA), Baidu (BIDU), and Tencent Holdings (TCEHY), their valuations haven’t yet sunk to “rush out and add more now” levels.

Managers are steering clear of companies in industries likely to see increased regulation: online gaming, education, and pharmaceuticals.

Chinese exporters could fare worse in the near future. The renminbi neared its weakest point against the dollar in a decade, down 6% for the year, which has helped Chinese exporters stomach the 10% tariffs so far. But those tariffs are set to rise to 25% in January.

There’s also the risk of an all-out trade war, which would cause global growth to slow. Semiconductor stocks and multinationals like Apple (AAPL) would take a major hit in that scenario, Jain says. One potential long-term beneficiary of a trade war: Southeast Asian countries, like Thailand or Malaysia, as companies begin investing in new production capacity there.

In other words, bargain-hunting in this particular bear market won’t be easy. Investors are best-suited with a fund managed by someone with experience in the region.

Here are five funds with strong track records that are positioned well to navigate the selloff.

For investors looking for China-focused active funds, the $291 million Templeton China World fund (TCWAX) has navigated the year’s declines well, with its 8% loss beating 98% of other China-focused funds grouped by Morningstar. Its 1.85% price tag is high, but over the past three years, the fund has lost less than peers better during downturns. The fund also has a higher weighting in consumer-oriented companies than its index, positioning it well if China’s stimulus focuses on boosting consumption.

The $706 million Matthews China fund (MCHFX), co-managed by Mattock, is a cheaper option, charging 1.09%. Over the past three years, the fund has outperformed other regional Chinese funds grouped by Morningstar by three percentage points, though it has ranked in the bottom half this year. Morningstar describes it as a fund that can handle rough spells, giving it high marks for its risk-adjusted returns.

While Mattock says the fears about China’s prospects are valid, he thinks the market has overstated their probability. Valuations of the high-quality companies he favors are roughly 15% from the lows they reached during the global financial crisis, and Mattock has been using the selloff to buy more of companies that dominate, have strong brands, and good cash generation.

Mattock’s colleagues at the Matthews Pacific Tiger fund (MAPTX) have a wider mandate across Asia and hold more in Southeast Asian countries than peers, with 5.7% of assets in Thailand and 4.4% in Malaysia. That fund has beaten two-thirds of its peers this year and consistently lost less during downturns than the average for Asia-Pacific funds, according to Morningstar.

For another broader fund, the $1.6 billion MFS Emerging Markets Equity fund (MEMAX) also has a strong long-term record and focuses on companies with low leverage, strong governance, and good free cash flow and return on invested capital. That focus has helped recently, with the fund’s 14% loss year to date, beating 82% of its peers.

The $789 million all-cap Invesco Asia Pacific Growth fund (ASIAX) often stands apart because of its focus on valuations. Co-manager Steve Cao, who has been on the fund since 1999, will avoid big weightings in popular stocks if valuations aren’t right. (Alibaba, Tencent, and Baidu aren’t in the fund’s top holdings.) Over the past 15 years, the fund has generated a return of 11% a year, beating 85% of peers, according to Morningstar.

During this year’s selloff, Cao has been adding to consumer companies like Yum China and China Mengniu Dairy (CIADY). So far this year, its 14% loss puts it in the top third of its Morningstar category, with his cautious bargain-hunting bent coming to good use.

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