Why this out-of-form area offers opportunities for the bold and brave

In the latest monthly column, Morningstar highlight a region offering attractive prospects due to its cheap price tag.

The Chinese equity market is difficult to ignore as it dominates the Asian and emerging markets equity universe. It’s the largest single country allocation in both the MSCI AC Asia ex Japan index and the MSCI Emerging Markets index, with weightings of 32% and 27% respectively.

In total, there are more than 4,000 Chinese companies listed across various exchanges, with the largest stocks in the MSCI China index, Tencent Holdings Ltd (SEHK:700) and Alibaba (NYSE:BABA), having market capitalisations of approximately $350 billion and $200 billion, making them large-cap companies in a global context.

• Explore our: Free regular investing | Top Investment Trusts  | Transferring an Investment Account

The Chinese equity market explained

Exposure to Chinese companies can be obtained through various exchanges. In addition to companies listed on the Hong Kong Stock Exchange (‘offshore’ stocks), overseas listings are also available (primarily American Depositary Receipts traded on US exchanges), but by far the largest markets are those in mainland China.

Stocks traded on the mainland China exchanges of Shanghai and Shenzhen are called A-shares. Foreign ownership of these stocks was via qualified foreign investor quotas until 2014, when a more accessible system was introduced; Stock Connect, which was introduced for the Shanghai exchange in 2014 and for Shenzhen in 2016.

• Sentiment to China has never been so dire, top investor says
• China’s stock market crash: biggest fund, trust and ETF losers

This opened the onshore market to foreign investors. However, trading on these exchanges remains dominated by domestic retail investors. The influence of retail investors gives the onshore market more sentiment-driven dynamics. As a result of this and differences in sector composition, returns between the offshore and onshore markets can differ markedly over shorter time periods.

The mainstream benchmark covering China, the MSCI China index, includes stocks from across all exchanges. In terms of A-shares, the allocation is close to 19% for this index.

Is there an opportunity for investors to ‘buy low’?

First, we need to state that the Chinese equity market is not for the faint-hearted. Over the past three quarters of 2022, the market (MSCI China Index) has shown sterling returns of -11.7%, +12.12% and -15.68%, giving investors a very bumpy ride. That said, there are reasons to be positive for those with a longer-term mindset.

• Investing in China: buying opportunity or not worth the risk?
• The pandemic fund and investment trust winners that have crashed

Valuations are low relative to history on an earnings basis and Morningstar Investment Management (MIM) highlights Chinese equities as offering some of the most attractive prospects based on their long term, valuation-based investment process. There have been various issues impacting economic growth and weighing on sentiment in the recent past, including the strict zero Covid policy, issues within the property sector and regulatory interventions. However, there are signs that these issues will lessen in importance in the future, with measures being introduced that could allow a relaxation of the Covid lockdown policy that has been impacting growth, and other plans aimed at stabilising the property sector.

Many commentators also highlight the potential for fiscal and monetary easing to boost the economy.  

Investment trust ideas

For those interested in this area of the market, there are options on the interactive investor Super 60 list of investment ideas.

Fidelity China Special Situations (LSE:FCSS) offers investors exposure to Chinese companies across exchanges and including an allocation of up to 15% in unlisted names. The trust has been managed by Dale Nicholls since 2014 and tends to show a bias to small and mid-cap stocks relative to the MSCI China index.

There are elements of gearing and shorting, but the clear focus for Fidelity China Special Situations is on stock selection. Net asset value (NAV) returns have been in line with the index year-to-date, but market returns have been impacted by the widening discount.

Longer-term performance remains strong. The experienced Nicholls holds a Morningstar Silver rating on his open-ended Pacific fund (which can have up to a third of its assets in China), and he is well regarded for the way he extracts value from the Fidelity research team.   

For those not willing to take such a focused approach, JPMorgan Emerging Markets (LSE:JMG) provides broad exposure across the emerging regions, including over one-fifth invested in Chinese stocks.

The fund benefits from highly experienced manager Austin Forey, a proven, growth-biased investment process and a large research team. This team includes a substantial resource dedicated to Chinese equities, covering both the onshore and offshore markets and giving the manager a wealth of ideas and high-quality support in this area. The trust holds the highest Morningstar Analyst Rating of Gold.

Simon Dorricott is director of manager research at Morningstar.