Chinese stocks are hot right now, but before jumping in its important to assess why they are doing well and whether their run is set to continue. Sure, China’s rapid recovery from COVID, as well as its long-term growth prospects and stable of dynamic companies has led to strong year to date performance, with the Shanghai Index is up almost 12%, and the CSI up 22%.
But, with that kind of performance, you need to ask if it’s too late to get in, because when looking at China, you also need to evaluate risks such as questionable accounting practices, deterioration in relations with the U.S., and poor historical performance. And of course the dragon in the room is the Chinese government itself, and its interference in the corporate sphere.
Why you should avoid China
For starters, Chinese stocks have performed poorly over time, despite the recent surge. In fact, the Shanghai Index is actually down over the last five years, and only up marginally over the past decade. That run of poor performance might give you pause before investing, because after all, its not like China is a newly discovered secret. It’s been the world’s fastest growing major economy for years, and boasts well-known companies like Alibaba (BABA 0.69%) and JD.com (JD 3.24%). But if that hasn’t been enough to spur strong returns, you might ask yourself what’s changed to alter the landscape.
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After all, Chinese accounting standards still lag those in many other countries. Plus, there is little doubt that relations with the United States have soured under President Trump, and executive actions from the current lame duck White House could lead to short-term volatility. And even once Biden takes office, there is little indication that the incoming administration will take a softer tone towards China.
Of course, it’s the Chinese government that’s’ ultimately the dragon in the room. China is after all a communist country, while investing is a capitalist enterprise. China’s worked hard to overcome this dichotomy, with mixed results. Many companies are left alone to operate, provided they don’t get involved in politics or anger the central government. But the recently canceled IPO of Ant Financial serves as a reminder that the government can operate as it wishes and in ways that may not be in an investor’s best interest.
Why you can’t avoid China
Chinese stocks have fallen slightly over the last five years, while the S&P 500 is up nearly 80% during that period.This might mean that Chinese stocks have room to run, particularly because many global investors have been scared away by trade war concerns, providing the potential for an influx of fresh investment at a time when the country’s’ weighting to international indexes is increasing.
And then there is growth. In fact, according to Matthews Asia, China accounted for 41% of global growth in 2019, and is forecast to account for as much as the U.S. and Europe combined over the next several years. Even though research has shown there isn’t a clear linkage between economic growth and stock market performance, a growing pie does offer the opportunity for companies to grow their profits.
China is also becoming less reliant on exports, with over 50% of GDP now coming from domestic consumption. That increase in domestic demand could help offset any slowdown in global trade, whether that slowdown is prompted by the COVID-19 pandemic or trade squabbles with the United States and its allies.
So, what should you do?
Yes, China is risky. And yes, the lack of accounting transparency is concerning, while heavy-handed government interference is a potential wildcard. But consider this: the total market capitalization of Chinese stock listings (Shanghai, Shenzhen, Hong Kong, and U.S. listed ADRs) was $14.1 trillion at the end of June 2020. For comparison sake, that’s almost twice the listed market cap of the Euro Area ($7.8 trillion.)
Does it really make sense to avoid a market twice the size of the Euro Zone? Doing so would effectively amount to an enormous bearish bet on the world’s second largest economy. And given its growth prospects and stable of world-class companies, betting against China may not make much sense.
While you can go out and buy specific companies, doing so might limit your options, because once you move past a couple of dozen corporate titans, accounting transparency might be an issue. Instead, a fund might provide more diversification and remove company specific risks. Keep in mind though that many broad emerging market funds focus on the largest Chinese companies. While many of these might thrive, they are also the companies most likely to attract attention from the Chinese government.
A better way to get exposure to the Chinese growth story, while avoiding potential government interference, might be a China specific fund focused on the “A” share market. These smaller companies tend to fly under the government’s radar, and might also offer superior growth potential. In fact, if you can stomach the volatility, a broad allocation to small and mid cap Chinese stocks just might be one of the best performing investments in the years to come.
