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.
Our positioning in China
Contrarianism is built on the premise that we might go where others do not. 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.
We 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 8x and 9x, respectively. Baidu, China’s Google, trades on a P/E multiple of under 5x 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 that 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
Despite a sea of negative sentiment, equities in the world’s second-largest economy have held their ground in recent months. So, what has changed in China’s macro picture to drive up these 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 that support the ‘less bad’ economic situation.
For example, we have seen 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.
There have also been government-mandated purchases of large-cap stocks by state-owned funds to boost the benchmarks, as well as a pledge of continued support for the economy and new housing policy measures to alleviate the property sector’s drag on the economy and revive the property market.
We are also witnessing a ramp-up in special bond issuance and newly announced ultra-long-dated government bonds. All actions that give us reason to be optimistic.
But momentum is slowing and markets have now entered a vacuum period as investors wait for the government’s upcoming Plenum meeting in July.
The party is expected to roll out measures aimed at boosting consumption and providing further relief to the beleaguered property sector.
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 have 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, but these 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.
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. So, even if this isn’t the bottom, we are happy owning our companies given the valuations and shareholder returns.
After three years in a bear market, few believe in China, and it remains a consensus underweight. Valuations remain attractive, however, and sustained market moves higher may convince more people to buy and eventually real money will come.
James Cook is head of investment specialists and investment director, emerging markets at Federated Hermes. The views expressed above should not be taken as investment advice.