The case for China
Contrarians have been rewarded in the past by taking the opposite view of the market. They’re looking to China now.
Recently, I wrote a piece on the lessons that investors can learn from Japan. One of these lessons is when to take advantage in opportunities – even if they might be a little uncomfortable.
It’s uncontroversial to say that taking an outsized position in Japan in the 20 years following 1989 would have made you a contrarian. Being contrarian is hard because you lose the validation that comes from traveling with the herd. It is human nature to seek validation, especially as investing your hard-earned money is an inherently emotional endeavour.
Contrarian investors can be rewarded handsomely. The Nikkei has outperformed the ASX/200. If you had invested $100,000 in July of 2008, and $1,000 every month from there, you would have close to $450,000 from the Nikkei 225. An investment in the ASX would have resulted in $320,000.
Purchasing assets at lower prices means that there is a greater potential for returns, and therefore less risk. This works out well if a quality asset is purchased. Quality was an issue with Japan. There were regulatory and market risks impacting Japanese companies. These risks lead to uncertainty of cash flows.
These same questions are being raised now about China. There are regulatory differences between western democracies and a political structure which puts the interest of the state above those of individuals and private property. The share market also suffers from a perceived lack of fairness with reports of rampant insider trading.
However, these risks may be muted by low valuations. China is one of the most undervalued regions according to our Price to Fair Value indicators, and Morningstar Investment Management.
Morningstar Price to Fair Value of China (as of 12 September 2023)
Investing in China would make you a contrarian. Investing is a trade-off between risk and reward. At a certain price, even a high-risk investment may be worthwhile for an investor. Morningstar’s Fair Value estimate helps investors understand whether a stock - or a market - is undervalued.
We form a view of an overall market by taking the fair value of each share we cover in that market and rolling them up to the country level. This is a bottom-up way to assess a market that helps investors see past the current market price. Currently, China is at a 0.70 Price to Fair Value, indicating that Chinese shares in our coverage universe are undervalued by 30% in aggregate.
How do emerging markets fit into investors’ portfolios?
Investors have been wary of emerging markets in the past as they are not as well researched or as saturated a market as US or Australian equities, but it is for this exact reason that they are full of opportunity.
Source: Manulife Investment Management, Macrobond. Investment growth of $100,000 (Developed markets represented by the MSCI World Index and Emerging markets by the MSCI Emerging Markets Index)
Undiscovered or unknown investments have high growth potential and can be attractive (see graph above which shows the growth of $100,000 in emerging markets and developed markets). Investors have also been turned off emerging markets because it can be time consuming, especially if the due diligence is done yourself. There are quite a few hurdles which you may face such as different languages, account standards, access to information and customs that can complicate relative investment valuations.
The first signs of increased interest in investing in emerging markets was during the early 2000s. Investors saw that China was experiencing incredible growth and providing much more attractive returns as it was cementing its place as an economic powerhouse. The short-term returns were extremely attractive for investors, and from 2000 – 2009, the MSCI Emerging Markets Index, net of dividends, had an annualised return of 9.78%, compared to the S&P500 returning -0.95% annualised and MSCI World ex USA 1.62%.
However, emerging markets can also display drastic differences in returns depending on the timeframe and year you look at.
The darker side
It is evident that emerging markets draw a certain attraction with their potential for high growth, but there is also a darker side to these investments. If we look at the following decade from 2010 – 2019, the MSCI Emerging Markets Index returned 3.68%, World ex USA 5.32% and S&P500 13.56%. When we smooth out the returns like this, we ignore a particularly important consideration with emerging markets investing – volatility. Between 1988 and 2019, emerging markets outperformed US stocks by 34 percentage points or more per year four times (1993, 1999, 2007, and 2009) and underperformed US stocks by that same magnitude four times (1995, 1997, 1998, and 2013).
Emerging markets would fit into an investor’s international equity exposure. The extent of inclusion will depend on your risk capacity. Although emerging markets can provide investors with stellar returns, they require long time horizons to balance the short-term volatility.
They would also suit investors that are not heavily reliant on dividends as a source of income. Emerging market companies may have strong growth prospects, but the volatility of the regulatory, legislative, and competitive environment means that income, if any, is not reliable.
The current state of emerging markets and China
When we look at the current state of valuations for emerging markets, we can get an indication from the price to earnings ratios (P/E) across ETFs. The MSCI World All Cap index has an overall price-earnings ratio of 20.72*, the iShares S&P 500 (ASX: IVV) sits at 19.99* and the MSCI emerging markets index sits at 14.2 (as of 31 August 2023). On a relative basis, emerging markets are appearing cheaper than all markets, and the US.
When we single out China, the iShares MSCI China ETF has a P/E ratio of 12.61 (as of September 8, 2023).
Regardless of the attractive valuations, investors are wary. The collapse of developers like Country Garden is still fresh in investors’ minds, and a huge focus on protectionist measures by President Xi has suffocated growth for Chinese based multinationals.
This aversion has meant foreign divestment from Chinese markets. Reuters reports that US based actively managed funds are close to their lowest allocations to Chinese equities in the past ten years. The exposure of managers has fallen to the second percentile, where 100 is the previous peak weighting.
However, contrarian investors and managers believe that the opportunity outweighs the risk.
The case for China
Morningstar Investment Management believe that China’s disappointing economic economic indicators, including weaker growth, retail sales, and high youth unemployment has seen sentiment turn highly negative.
Chinese companies are also under earning relative to history. Their thesis is that once there is a stabilisation in profits, Chinese markets will strengthen.
Morningstar Head of Multi-asset Research James Foot says that the balance between risk and return presently favours Chinese Equities. This is due to highly attractive valuations, particularly among the Chinese Tech names.
He adds that it’s not all upside, “Despite this attractive skew, there is a small chance of large losses that could stem from a material escalation in geopolitical conflict.”
He suggests investors should consider this in their portfolio sizing, and how much Chinese equity exposure they take on.
Making a tactical asset allocation decision should not be done lightly. Regardless of the rationale, this is market timing. However, investors can take advantage of undervalued opportunities if they have liquidity, they are not deviating too far from their strategic asset allocation and they have the time horizon required for the investments that they are investing in.
Medalist ETF exposure
The Vanguard FTSE Emerging Markets Shares ETF (ASX: VGE) has been awarded a bronze medal from our analysts. The Morningstar Medalist Rating provides investors with assessments of a strategy's ability to outperform its Morningstar Category index after fees It’s the highest rated emerging markets ETF under our coverage, with the highest allocation to China.
Investors can also gain exposure to other undervalued markets such as South Korea (currently 0.78 Price to Fair Value).
Our analysts believe the Vanguard FTSE Emerging Markets Shares ETF (ASX: VGE) presents a compelling, cost-effective option for investors seeking to gain emerging market exposure in their equity portfolios. Emerging markets are perceived to offer investors nonlinear growth opportunities and higher expected returns relative to the developed markets—not to mention the diversification benefits that come with it.
This index is a compelling choice for emerging-markets equity market exposure as it provides access to a broad portfolio spread across the entire market-cap spectrum from 24 emerging-markets economies. The portfolio effectively diversifies stock-specific risks by holding over 4,000 stocks, which should mitigate the impact of the worst-performing firms.
Investors that have a long timeline and are agnostic on dividends may decide to invest in currently unloved China. Although some active managers are divesting, contrarian investors such as Morningstar Investment Management see echoes of Japan when looking at the current state of the People’s Republic.