China, Explained series: What to look out for when investing in China’s stock market
Foreign investment in Chinese stocks has been on the rise.1 While China’s capital market liberalization has been ongoing since the early 2000s, the launch of the Stock Connect program in 2014 has significantly improved investor access to Chinese equities and has propelled participation.2 As more international investors gain exposure to this market, Corinna Lau, Head of Asia Products within Invesco’s Asia Equity team, highlights some common pitfalls they can look to avoid.
1. Falling into the “value trap”
So far 2021 has been a volatile year for Chinese stocks with notable sector rotation out of growth stocks. In this environment, investors may be at risk of picking value stocks that can appear cheap but have little growth potential. Careful bottom-up stock selection with a focus on fundamental analysis can help investors differentiate a value trap from a worthwhile investment opportunity. At the sector level, investors can opt for structural growth areas that exhibit higher future earnings growth. However, it is even more important for investors to focus on stock-specific selection. They can use fundamental research to choose names with good earnings quality that are supported by robust metrics including the strength of the company’s management, its corporate governance track record and ESG credentials.
2. Chasing momentum
Earlier this year, Chinese electric vehicle stocks as well as shares in related industries staged a strong momentum-driven rally that drove their valuations to record highs.3 Although the momentum trade may have been a successful strategy at the time, some investors subsequently realized losses when the market corrected later.4 That being said, not all momentum is bad. The key is to distinguish between riding on momentum as opposed to chasing it. Investors can rely on fundamental research and move early in the stock selection process in order to identify secular growth trends with strong earnings potential. For example, given the rising importance of e-commerce distribution channels in China, our team positioned early to an e-commerce company that had strong fundamentals prior to the pandemic. Since the COVID-19 outbreak, the company has performed well and added strong alpha given the acceleration of digital trends in the country. Investors can also prioritize industries and companies that have high barriers to entry as well as a sustainable competitive edge.
3. Discounting policy signals
As with any investment decision, it goes without saying that it is worth monitoring policy signals when buying stocks. However, this is particularly true in the current environment. As economies globally begin to recover from the COVID-19 pandemic, uncertainty over the pace at which the Fed will raise rates has been the subject of news headlines in recent months. In China however, the process of policy normalization is already underway. As the country has been quick to recover from the outbreak, Beijing policymakers signaled their intentions for normalization as early back as the second half of 2020.5 At the National People’s Congress in early March, regulators also reiterated the need to strike a balance between promoting economic recovery as well as risk prevention.6 Therefore we believe China’s stock market has already largely priced in policy normalization risk. Given its discount to other asset classes, we believe there is still upside potential for valuation expansion.
4. Overlooking on-the-ground research and local insights
The importance of on-the-ground research and local knowledge when evaluating China’s stock market cannot be understated. China’s weight in the MSCI EM Index has risen significantly in recent years to roughly 40% as of August 2020 from less than 25% five years ago.7 The rising country-level concentration also means investors are increasingly looking to have dedicated China-specific allocations (rather than simply tapping into a few large names). It is therefore vital for investors to have access to strong local research and insights so they can accurately assess this expanded universe and uncover sources of alpha. By having a trusted partner with a strong local presence, foreign investors can better navigate the nuances of this growing market. Beyond language, what is popular, trendy and “invest-worthy” in China can be quite different to other countries. For example, given the cultural preference for hot food in this part of the world, sales of self-heating instant foods sky-rocketed in China coinciding with the onset of the COVID-19 pandemic and subsequent country-wide lockdowns (while in contrast, this same level of interest has not been shown in western markets).8
Investment risks
The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.
When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.
Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.
^1 Rising foreign investment in Chinese stocks and bonds shows deepening financial integration, July 2020, https://www.piie.com/research/piie-charts/rising-foreign-investment-chinese-stocks-and-bonds-shows-deepening-financial
^2 China A Shares: What Have We Learned?, October 2020, https://www.msci.com/www/blog-posts/china-a-shares-what-have-we/02164045217
^3 Electric vehicle stocks rally after strong demand reports from China, January 2021, https://seekingalpha.com/news/3648379-electric-vehicle-stocks-rally-after-strong-demand-reports-from-china
^4 Nio, Li Auto, Xpeng: What’s Driving The Sell Off In Chinese EV Stocks?, April 2021, https://www.trefis.com/stock/xpev/articles/513311/nio-li-auto-xpeng-whats-driving-the-sell-off-in-chinese-ev-stocks/2021-04-19
^5 Wang Tao: Policy Normalization Won’t Be a Drag on China’s Recovery, April 2021, https://www.caixinglobal.com/2021-04-14/wang-tao-policy-normalization-wont-be-a-drag-on-chinas-recovery-101691139.html
^6 China NPC Wrap-up, March 2021, https://www.research.hsbc.com/C/1/1/320/WsQHzLd
^7 A Decade of Change in the MSCI Emerging Markets Index & A Look To The Future, October 2020, https://kraneshares.com/a-decade-of-change-in-the-msci-emerging-markets-index-a-look-to-the-future/
^8 Self-Heating Fuels Instant Food Innovation In China, 2021, https://www.mintel.com/blog/food-market-news/self-heating-fuels-instant-food-innovation-in-china
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IM2021-029
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