Chinese stocks have long been both fascinating and fearsome to American investors.
On the one hand, it’s easy to understand the potential in a nation of 1.4 billion people, many of whom are joining the ranks of the middle class. It’s also easy to understand consistently high economic growth rates, even if they have slowed from nearly 15% 10 years ago to just under 7% today.
On the other hand, risk can be higher. China is not a democracy, and the government can change things at any time.
That said, this combination of higher perceived political and geographic risk often leads to attractive valuations in stocks.
Most recently, the talk of a potential trade war between the U.S. and China has hit Chinese stocks hard. The Shanghai Composite Index is down 20% from its highs set early in 2018 – shown in the chart of the KraneShares Bosera MSCI China A ETF below – and many are now trading at valuations not seen in years.
So what’s the right move?
Definitely Buy But Be Selective
The opportunities in select Chinese stocks are simply too good to pass up. That doesn’t mean I’m an all-out China bull, and it doesn’t mean all Chinese stocks are equal. It does mean there is big potential for big money in certain companies and sectors.
Part of the reason is valuations. The P/E ratio for the Shanghai Index is now down near 10, well below 17.5 for the S&P 500. Valuations become even more attractive when you consider that earnings growth in China is expected to increase at a faster pace than the U.S.
The discount comes down to the fear of a trade war, and some investors are not willing to bet on a resolution between the two countries. I never believed a full-blown trade war would be the end game, and based on what we’ve seen so far, I still don’t. Yes, there are headlines and posturing, but neither country wants or needs to go that far.
Plus, the stocks I would be buying are the ones with tons of potential over time, even if there was a short-lived trade war.
The Netflix of China
I especially like opportunities in companies that have the potential to become the Chinese version of a wildly successful counterpart in the United States or other countries.
For instance, I’ve been recommending a company that is set to become the Netflix of China. Here’s why it has so much potential. In 2002, Netflix (NFLX) had less than three million subscribers. By 2018, it had reached 125 million subscribers. The company now sports a market valuation of $165 billion.
To give you an idea of how an investor would have done with an early Netflix stake, consider that NFLX fell to a split-adjusted low of $0.35 per share in 2002. Even if you had invested not at the bottom but at $0.50 per share, a $5,000 investment would now be worth $3.67 million.
The market gave investors another big Netflix opportunity in 2012. Back then, the stock dipped to $7.58 per share because of concerns about the large losses the company was incurring due to rising costs. An investment of $5,000 at that time would have ballooned to $242,381 in less than six years (a 48-fold win).
Think about it. The companies that dominate social media, video games, media, and the internet in the United States are some of the biggest stock market winners of the past 20 years. I’m talking about Google (GOOGL, now known as Alphabet), Facebook (FB), Netflix and video game giant Activision Blizzard (ATVI). They remain the leaders of the current bull market 20 years after they started to take off. If their Chinese counterparts follow the same path, there is more than a decade’s worth of gains ahead.
The population of the U.S. is about 330 million. The population of China is 1.38 billion. The Chinese government uses laws and regulations to restrict (and sometimes prohibit) non-Chinese companies doing business in China. This policy allows home-grown businesses to do well.
The Netflix of China is a company called iQIYI (IQ), which I believe will emerge as one of China’s major media and entertainment winners. I shared my full analysis on the company with my Investment Opportunities readers a few months ago, and the recent pressure on Chinese stocks in general means it’s still a great buy.
It’s not too late to learn all you need to know about this company and the opportunity ahead. There are others as well. The recent weakness has provided some great buying opportunities, but you need to stay selective.