Investors Need to Change Their Perspective on Chinese Stocks

Chinese stocks - Investors Need to Change Their Perspective on Chinese Stocks

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Perspective is a funny thing. Sitting in your office in the U.S., it’s hard to grasp the size, scale and potential of China’s domestic economy. But a change of location can really open your eyes.

A few months ago, I visited Shenzhen, a booming metropolis that is not only headquarters for some of China’s most-interesting technology companies, but also home to a burgeoning exchange where a huge number of domestic stocks are traded every day.

I’ve chosen my words carefully here, because booming domestic opportunity when it comes to investing in the world’s second-biggest consumer economy.  And this week, China’s consumer confidence reached its highest point since Nielsen started tracking it in 2005.

Flying Pigs

Around the time I was in Shenzhen, Wall Street went overweight on China. Goldman Sachs Group Inc (NYSE:GS), Morgan Stanley (NYSE:MS) and Credit Suisse Group AG (ADR) (NYSE:CS) all told clients that it was time to play the domestic recovery there.

That theme was reinforced to me this week when I sat down with Jian Shi Cortesi, who manages the $102 million GAM China Evolution Fund. China Evolution is not available to U.S. investors, but many of the stocks in the portfolio are (see below). Lipper has named the fund the best China equity fund for each of the last three years; Morningstar gives it a five-star rating.

“There’s a Chinese saying that translates roughly to ‘If you’re at a place with strong winds, even a pig can fly’,” she said. China’s domestic economy is at that place now and there are domestic consumer-focused companies that are poised for significant growth, she said. Her perspective comes from 10-plus years covering Chinese stocks with a wide network of local contacts.

Why Investors Should Look at Chinese Stocks

Shi Cortesi is telling her clients to invest in Chinese stocks to ride the evolution toward a consumer-driven economy. That focus is leading her to pick companies in consumer goods and services, technology, healthcare and financial services. These are companies with low export exposure and low debt.

Her pitch to investors goes something like this: After underperforming the MCSI World Index by 70% from 2010-2016, Chinese domestic stocks are starting to catch up.

How does she know this?

To begin with, macro conditions are improving, including diminishing fears about the Chinese yuan. Shi Cortesi also likes the low valuations now in Chinese shares. The MCSI China Index in particular has forward price-earnings ratio of 14x. Finally, positions are light with most investors still underweight in Chinese stocks.

The fact is, most investors are not yet participating in China’s recovery.

Valid, but Overblown Concerns for Chinese Stocks

To be sure, there are still risks with investing in the Chinese domestic recovery.

For one, corporate borrowing is a big problem. This is much more of an issue in heavy industries with a lot of debt and poor profitability, however. And that’s why Shi Cortesi favors investing in low-debt sectors (consumer, healthcare and tech).

And while there’s less fear about the direction of the yuan versus the dollar since China’s been able to stabilize its foreign reserve, and capital outflows have subsided, Shi Cortesi still avoids stocks of companies with heavy U.S. dollar debt burdens to mitigate this effect.

Another concern raised by emerging markets investors that I’ve talked to is the structure of the companies underlying the sought-after Chinese stocks.

Many of China’s most-familiar names — including Alibaba Group Holding Ltd (NYSE:BABA) and Tencent Holdings Ltd (OTCMKTS:TCEHY) — are what’s known as “variable interest entities” (VIEs), a kind of corporate architecture used mainly by China’s tech firms. Investors outside China have about $1 trillion invested in firms that use them, according to The Economist.

More than 100 companies are using this VIE structure. “Since the 1990s private firms have sought to break free of China’s isolated legal and financial systems. Many have done so by forming holding companies in tax havens and listing their shares in New York or Hong Kong,” the magazine wrote last September.

As they explained, the problem is that as VIEs, the companies are categorized as “foreign firms” under Chinese rules. This prohibits them from owning assets in some politically sensitive sectors, most notably the internet.

So why use this structure? Mainly because it gives the Chinese entrepreneurs and tycoons more power, hence the concern. The structure makes it difficult for outside shareholders to keep a close eye on what’s actually going on. So far, this hasn’t been a problem.

Some Chinese Stocks With Less-Familiar Names

Things change fast in China.

I saw that in Shenzhen. And the same is evident in the names that Shi Cortesi and her team have picked for the GAM portfolio. Yes, there are a couple of the usual suspects in her holdings — notably BABA and TCEHY — but a handful of other Chinese stocks caught my eye.

One is Ping An Insurance (OTCMKTS:PNGAY) which is a play on both financial services and underlying technology serving the domestic Chinese economy. With a market cap of almost $82 billion, the shares have more than doubled in the last 12 months and are on their way back from this month’s correction.

Another is Inc (ADR) (NYSE:WUBA), which is riding the service consumption trend among China’s increasingly affluent and busy urban dwellers. The company operates online classifieds and listing platforms, giving local merchants and consumers a place to connect, share information, and conduct business.

The other less-familiar name in her portfolio is YY Inc (ADR) (NASDAQ:YY), small in comparison, with an $8.4 billion market cap. The video-based social media company has 300 million users and has expanded cash from operations every year since 2014, as pointed out by Ascendere Associates’ Stephen Castellano.

Shi Cortesi also likes Baidu Inc (ADR) (NASDAQ:BIDU), aligning with InvestorPlace contributor Nicholas Chahine on the shares, though for different reasons. Nick likes the shares on the recent pull-back and the momentum that he sees for the next few months. Shi Cortesi is looking longer and deeper at BIDU stock. She’s particularly focused on the company’s interests and investments in artificial intelligence to drive future growth. That AI ecosystem gives the Beijing-based tech firm entrees into big data, robotics and the thing that seems to be dominating every technology-related conversation these days: autonomous driving.

For ETF investors, a number of these Chinese stocks — as well as others in the GAM China Evolution portfolio — are among the largest holdings of Guggenheim China Technology ETF (NYSEARCA:CQQQ) and PowerShares Gld Drg Haltr USX China (ETF) (NASDAQ:PGJ).

An Evolving Economy

If you look at the data, it’s clear that China is evolving from a manufacturing and infrastructure focus to a consumer-driven economy.

It’s back to perspective. Again, sitting in Cleveland or Chicago, there’s a tendency to think of the world’s number two economy as the place where all of the manufacturing jobs went. Yes, they did. But that was then. This is now.

And now, in China, it’s an economy where service and consumption are becoming the main economic drivers. Chinese wages have been on a trajectory since 2005 that shows no sign of letting up. That money is being spent furiously, fueling what is fast becoming known as the “Happy Economy” built on Chinese stocks.

As of this writing, Robert Lakin did not hold a position in any of the aforementioned securities.

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