The Case for Investing in Chinese Stocks

China is a complex country. Its rapid growth and industrialization put it in the class of emerging nations, but its vast size lends it some qualities of a developed country. In just a few decades, China has accomplished “one of the most rapid and far-reaching transformations of a major economy that the world has ever seen,” says Robert Horrocks, chief investment officer at investment firm Matthews Asia.

China is already a global powerhouse, the world’s second-largest economy and the biggest exporter of goods on the planet. Now it’s in the throes of a new phase of economic development—one driven by technology and consumer spending rather than focused on manufacturing and infrastructure.

Yet investors are skittish, and Chinese stocks struggled last year. In 2018, the MSCI China index sank 18.9%. One problem is that economic growth in the Middle Kingdom (a loose English translation of the Mandarin word for China) has been slowing. In recent years, the country’s gross domestic product has grown around 6% annually, down from the 10% average growth of previous years. Trade tensions with the U.S. haven’t helped.

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When it comes to China’s growth prospects, investors’ fears are “overdone,” says Kate Moore, chief equity strategist at BlackRock. “China is in very good shape to continue to be one of the largest economies in the world,” she says. Indeed, in early 2019, small signs of economic improvement and a positive step toward a U.S.–China trade agreement sent the MSCI China index soaring 22.2% over the first 16 weeks of the year. (Prices and returns in this story are as of April 19.)

The wide market swings show that investors, reacting to the headlines on any given day, can “miss the forest for the trees,” says Peter Donisanu, a Wells Fargo Investment Institute strategy analyst. The Asian powerhouse is on a long-term growth trajectory. “China still faces a long road to catch the most developed countries,” says Donisanu. “It has only half started.”

The bullish take

China’s 6% GDP growth rate—the government’s official target—is still robust relative to the rest of the world. It’s three times the average for the developing world and 43% faster than other emerging nations, on average. China has a history of meeting announced growth targets, and “we believe they will deliver,” says Moore. She adds that China watchers today have more tools to assess the accuracy of China’s official data, including satellite imagery and even social media. “The tools and available data allow us to have greater confidence in our views around Chinese growth than we might have had a decade ago,” says Moore.

New initiatives launched in 2013 and 2015 are aimed at sustaining growth. One is focused on increasing trade opportunities between China and countries in Africa, the Middle East, Europe and Asia. Another fosters homegrown technological innovation, among other things. Beijing has proved to be nimble and speedy about “fine-tuning” policies to achieve economic goals, Moore says. That’s one upside to having a centralized government. Decisions are made quickly, unlike in developed markets.

The Chinese stock market has become friendlier to foreign investors, too, thanks to looser rules regarding foreign investment in China. In addition to the Chinese stocks listed on exchanges in Hong Kong and the U.S., foreign investors can now buy select stocks that trade on the Shanghai and Shenzhen exchanges, known as China A-shares. “In the last three or four years, the number of investment opportunities has expanded,” says Andrew Mattock, lead manager of Matthews China fund.

The country’s second phase of economic development should resonate with global investors. Ten years ago, financials and energy were among the biggest sectors in the MSCI China index. Today, internet and other tech firms reign, along with financials and consumer goods and services. “Investors in the Western world can relate to these Chinese companies now,” says Mattock. Tencent Holdings, for instance, is the Facebook of China; Baidu is China’s Google; and Alibaba Group Holding is the Chinese Amazon.com.

Still, the risks of investing in this sometimes-dicey market haven’t disappeared. U.S.–China trade relations may be improving, but other tensions remain. “We expect U.S.–China relations to be tense even after a trade agreement is in place,” says BlackRock’s Moore. Competition in the global tech sector and cybersecurity are two hot buttons.

Credit worries loom, too. The country’s debt—including bank loans, corporate debt and government, state and private lending, plus shadow banking (lending by unregulated institutions)—now measures more than 200% of GDP.

And there’s the volatility. Emerging-markets stocks have always been rocky, but China stocks have been even more so. Brace yourself for corrections of 5% to 10% in any given year. “Investors should get comfortable with that. But they can use corrections to add to investments and hold for the longer term,” says Moore.

Ways to invest

One way to cash in on China is simply to beef up your exposure to a diversified emerging-markets stock fund. After all, China makes up more than 30% of the MSCI Emerging Markets index. And in November, after MSCI completes the last of several changes to that benchmark, the country’s fastest-growing firms will make up an even bigger portion of China stocks in the EM index. China is a big reason BlackRock strategists are bullish on emerging-markets stocks overall these days. “China is the key driver,” says Moore.

A growth-oriented investor might devote 10% of portfolio assets to emerging-markets stocks, says Wells Fargo Investment Institute. Such a bet represents roughly a 3% stake in Chinese stocks in your overall portfolio. Our favorite emerging-markets stock fund is Baron Emerging Markets (symbol BEXFX). Manager Michael Kass says he expects to see more-positive signals coming from China’s economy and corporate earnings later this year. The fund has 33% of its assets invested in Chinese firms, and Alibaba and Tencent are its top holdings.

But you might want to take a more targeted, and slightly heftier, position. The most aggressive allocation recommended by Wells Fargo, for instance, has nearly 6% in Chinese stocks (based on an 18% stake in emerging-markets stocks). Cambridge Associates, a Boston-based advisory firm, says holding 5% to 10% of total stock assets in China is reasonable, given the relative size of its economy and stock market in the world.

Exchange-traded funds are another way to invest. IShares MSCI China (MCHI, $65), the second-largest China-focused ETF, with $4.7 billion in assets, offers exposure to Chinese stocks listed on exchanges in China, Hong Kong and the U.S.

More-aggressive investors might consider SPDR MSCI China A Shares IMI ETF (XINA, $23). It has just $5.8 million in assets, less than we would prefer. But it focuses on the domestically listed A-share companies available to foreign investors, which Baron Emerging Markets manager Kass says include the country’s most exciting investment opportunities. “That’s where you’re going to find the next Tencent or Alibaba,” he says. Volatility is high, however. In 2018, the SPDR ETF lost 29.8%; the iShares ETF swooned, too, but only 19.8%. But the SPDR offering has rebounded faster and higher, up 39.4% in the first 16 weeks of 2019, compared with 23.3% for the iShares ETF.

Investors looking for a smoother path into China should consider Matthews China Dividend (MCDFX). The fund invests in dividend-paying Chinese companies of all sizes that have healthy balance sheets and generate steady profits and cash flow. About 90% of all publicly traded Chinese firms available to foreign investors offer a dividend, typically paid once a year. Over the past five years, China Dividend returned 12.5% annualized. That beat 93% of all China-focused funds, with 21% less volatility.

China Dividend’s managers, Sherwood Zhang and Yu Zhang, build a barbell portfolio. On one end are shares in stable firms in mature industries with fat payouts but average earnings growth. CapitaLand Retail China Trust, for example, a real estate investment trust, pays a 6.4% dividend yield. At the other end, the managers buy shares in smaller, fast-growing companies that pay modest dividends. China Overseas Property Holdings, a property management firm, yields 1.1%. For its last full fiscal year, which ended in December 2018, the firm reported 31% earnings growth, says Sherwood Zhang. The fund’s goal is a portfolio with an above-average dividend yield and above-average earnings growth, relative to the MSCI China index.

We like Matthews China (MCHFX), too. Winnie Chwang and Andrew Mattock run the fund, investing mostly in large, growing firms trading at reasonable prices. They limit the portfolio to a trim 35 to 45 holdings because it pushes them to be more decisive about their investment choices. “If we’re not 100% sure, we don’t buy it,” says Mattock. “You force yourself to do more work, and that tends to minimize mistakes.”

The duo travel in China extensively. Chwang and Mattock are based in San Francisco, but Mattock has visited some 90 Chinese cities. The idea is to glean investment ideas from 150 medium-size and large cities with 1 million or more in population. Since April 2015, the fund has gained 6.5% annualized, thumping the typical China fund’s 4.3% return.

The pair who run Fidelity China Region (FHKCX), Stephen Lieu and Ivan Xie, have been at the helm for only one year, but they have proved their mettle in that short time. The MSCI China index fell 3.3% over the past 12 months, but the China Region fund was flat, with a 0.3% gain. We prefer longer records, of course. But we think this fund, which also has 20 analysts worldwide behind it, is worth a look.

Lieu and Xie, who are based in Hong Kong, look for growing firms in greater China that trade at reasonable prices. The companies must be economically tied to China, but they don’t have to be headquartered there. Most of the fund is devoted to large firms with stable earnings, such as Alibaba and Tencent. But 25% of the portfolio is reserved for opportunistic plays, such as AirTAC International Group, a Taiwanese firm that builds pneumatic components for automated factories. The fund snapped up shares when the stock lost more than half of its value in late 2018, due to concerns over slowing growth in China. The stock has since rallied more than 70% from its 2018 low.