Chinese equities offer value, but risks lie ahead

Chinese equity markets have experienced a rough year, reflecting significant concerns about the slowdown in the world’s second largest economy, the stability of its property sector and regulatory crackdowns. However, after a big sell-off, Chinese companies now represent good value, according to experts.

Government regulations targeting specific sectors including internet platforms, education and property markets have wiped out over US$1 trillion ($1.4 trillion) of market capitalisation from Chinese equities since their recent peak in mid-February, according to Goldman Sachs.

Over the year to 25 November, the Hang Seng Index is down 9.4%, while the benchmark China A-Shares index, the CSI 300, which replicates the performance of the top 300 stocks traded on the Shanghai and Shenzhen stock exchanges, dropped 5.7%.

This is drastically different to the S&P 500 which is up roughly 25.2% and the S&P/ASX 200, up around 12.3%.

Technology giant Tencent (00700), listed in Hong Kong and the US, is down around 16.3% while the now infamous property giant Evergrande (03333) also listed in Hong Kong, is down around 53.0%, given concerns about the indebtedness of the country’s property sector.

Following the sell-off, UBS’ head of China equities, Bin Shi says Chinese equities are more attractive from a valuation perspective compared US markets and elsewhere – but political risks remain for investors. UBS believes China’s economic “policy is already moving through its tightest point” and earnings should bounce back next year, as weak earnings in Chinese internet stocks fade.

“But just because the market is cheap it doesn't mean the stocks will automatically go up,” Bin Shi said in a recent report.

“The big question for international investors is policy risk. We need more clarity and more consistency from the Chinese government to convince them to come back to the market,” Shi says.

Meanwhile, Todd Hoare, head of equities at Crestone Wealth Management, says China’s regulatory crackdown has raised the risk profile of investing in China – but it is still an important market for investors.

“The purpose of the regulatory drive is not to stifle innovation, but to make sure companies conduct business in a sustainable way, and not in a monopolistic, or anti-competitive way,” says Hoare.

“For example, few investors would suggest that a single company, Tencent Music, should have exclusive rights to 99% of the country’s music […] Recent commentary from regulators suggest that adherence to new rules has been very satisfactory, raising the hope that we may be closer to the end of the tightening regime.

“Given valuations, balance sheets and still strong, structural tailwinds associated with e-commerce penetration, cloud adoption, and digital payments, this raises the prospect that Chinese tech can perform well from here, albeit we suspect that multiple expansion may be capped.”

American Century Investments’ senior investment director – Asia Pacific, Chris Chen agrees. While China’s economic growth may be decelerating, it remains strong in absolute and relative terms, compared to other countries.

“It is true the change in the regulatory landscape in China has increased uncertainties investing in China. Having said that, there remain sectors where we have visibility – sectors with policy support from Beijing – such as electric vehicle value chain and healthcare innovation, which have now become more attractively priced after the recent correction,” says Chen.

“In short, we still see opportunities investing in China. Further, a decelerating growth environment can lead to greater differentiation between businesses, which puts greater importance on being selective in our Chinese equity investments.”

Danger in centralisation

However, not all experts on China are so upbeat, and investors need to be aware of the risks of further regulatory crackdowns on several sectors of the economy.

Jude Blanchette, the Freeman chair in China Studies at the Centre for Strategic and International Studies, believes China's recent regulatory crackdown is a prelude to a period of greater political centralisation and economic volatility ahead of next year's 20th National Party Congress.

“There's a danger of too much centralisation. Xi Jinping is increasingly calling the shots in China in relative isolation, especially compared to the level of collective decision-making in China a decade or so ago. That's not good for China's development because it increases the likelihood of political instability and erratic policymaking,” he says.

“Despite China's undeniable bureaucratic talent, regulatory decisions have become far more political in nature […] I'm much more cautious about China after these regulatory developments, which have given us a good sense of what regulation with Xi Jinping characteristics looks like: sudden, unpredictable and tending towards wild swings.”

Experts at Goldman Sachs agree. The regulatory changes in China have inflicted more than US$1 trillion of market capitalisation damage to Chinese equities since their peak in mid-February this year, with the losses mostly concentrated in the offshore technology sector, which represents 40% of MSCI China market capitalisation.

Timothy Moe, chief Asia-Pacific equity strategist and co-head of Asia macro research at Goldman Sachs says the regulatory tightening cycle is unprecedented in terms of its duration, intensity, scope and the velocity of new policy announcements, and further losses are possible for Chinese equities.

“With social welfare high up on the policy agenda, Goldman Sachs believes that US$3.2 trillion of market cap in what we deem ‘Risky Social Sectors,’ representing nearly 20% of the total market cap of listed Chinese companies, mostly residing in industries such as internet, education, media and entertainment, real estate and healthcare, could be disproportionately exposed to further regulatory attention,” he says.

“We believe regulations should impact companies’ future earnings trajectory and deflate their valuation premium in socially important sectors, but not to the extent that the profitability profile for new economy equities would be structurally impaired.”

But not all technology sectors are equally at risk.

China-based investment firm Primavera Capital Group chief executive Fred Hu believes hardware companies will fare better than software companies.

“As far as regulatory risks are concerned, the hard tech space is almost like a safe haven for investors,” says Hu.

“Recent regulations have significantly impacted the consumer internet sector—including fintech, e-commerce, social media, gaming, delivery, ride hailing and education tech—while the hard tech space, notably semiconductors, industrials, AI, robotics, medical tech and clean tech, has been completely spared from the recent tech crackdown.

“Some sectors like renewable energy and clean tech have actually benefitted from increased government support given the national priority of transitioning to a carbon-free economy,” he says.