Over the past few weeks, my conversations with managers of multi-asset funds have rattled through the usual stuff: US equities look expensive but don’t bet against them; the UK looks cheap but could be structural; Europe is a mess because of Germany; and fixed income is getting more interesting.

Then the chat moves to Chinese equities, and the fund managers mutter something guiltily about the country ‘looking very cheap despite the risks’. At which point I say: ‘Really?’ while thinking: ‘Not cheap enough I reckon.’

Nevertheless, in the spirit of a bright, cheery new year and with a willingness to embrace radical uncertainty, I thought I might return to the China question – is it really that cheap?

China is cheap

The hard facts tell you it is. My favourite chart heading came in a recent John Authers’ piece for Bloomberg that showed medium-term returns for various Chinese on and offshore indices and was headed: Wherever they are quoted, Chinese stocks are lower than five years ago.

Look at major indices such as the CSI 300 index and we are back to levels last seen in 2015. That’s nine years of phenomenal economic growth and technological change – all for nought in equity terms.

On most earnings-based measures, it’s hard to argue with the valuation argument. Take the CSI 300 index – its forward price-to-earnings (P/E) ratio is now a shade over 10. The comparative number for the US S&P 500 – depending on the exact earnings measure – is probably about 22. China is even cheaper than UK equities, and that’s saying something.

Skip to longer-term measures and Chinese stocks really are incredibly cheap. Using the cyclically adjusted Shiller PE ratio for the CSI 300, we’re at 13.4 times earnings, close to a multi-decade low of about 10 in the middle of the last decade.

Just in case you think I’m picking on the CSI 300, note that the equally widely tracked MSCI China index, using a measure based on the two-month forward P/E ratio, is currently at around nine times earnings, one standard deviation below the long-term average from 2013 of roughly 11.5 times earnings.

Beijing bureaucrats will act

Yes, then, Chinese equities are cheap. But cheapness at the asset class level doesn’t mean anything unless there’s a catalyst for an upward revaluation. With China, that is lunging into view as the country grapples with a long list of macro headwinds: the subsiding housing market; the increase in consumer savings rather than consumer spending; the export of goods inflation to the West as exports such as electric cars ramp up; and the weakening currency.  

If it’s obvious to me, you and the other billions of sentient human beings on this planet that China’s economy is in deep, deflationary trouble, I think we can safely say it’s obvious to those joyless communist bureaucrats who run the place.

Remember, they can read stuff outside of China’s Great Internet Wall – and Davos provided an opportunity for that. The direction of travel is increasingly obvious – something needs to be done. Whether that is Chinese quantitative easing, a version of the US Troubled Asset Relief Program, or deep structural reform to boost consumer confidence, I will leave to the experts.

It is not an unreasonable proposition that something big will happen in 2024 that will have an impact on local stock markets. If it doesn’t occur, the bureaucrats will tell the bosses of state businesses to buy shares and make it happen. 

Alibaba demonstrates the problem

On measures of valuation and likely catalysts, China passes the test, then. But to explain why I’m still not convinced by the bulls, I’d like to cite the case of Alibaba. In my subscriber letter last week, I ran a deep dive into the tech giant and featured a large bit of commentary by Citywire’s own Phil Oakley.

He had dug around in Citywire’s fund manager data and found that top investors have been buying Alibaba stock on valuation grounds.

Oakley observed: ‘Alibaba arguably suffers from having a conglomerate discount placed upon it. One of the ways the company can unlock value for its investors is to spin off some of its divisions. This was the plan for the cloud business, but it was unexpectedly pulled last month.’ 

At just over $74, Alibaba’s American depositary receipts share price equates to just eight times its next 12 months’ forecast earnings. Even more pertinently, the business has a ‘net cash equivalent to almost one-third of its market capitalisation’.

‘Based on a one-year forecast of enterprise value to earnings before interest and tax, which better reflects the substantial net cash position, the shares currently trade on just over six times, which is an all-time low,’ Oakley wrote.

It is not just Phil Oakley and a bunch of value fiends who are looking at Alibaba. Even the venerable US investment publication Barrons picked the company as one of its top 10 tips for 2024. It said: ‘Alibaba’s US-listed shares trade for just eight times projected earnings in its current fiscal year ending in March. With that decline, the stock, at a recent $72, is back where it stood following its 2014 initial public offering, despite a tenfold rise in revenue and a fivefold increase in earnings. Its market cap is less than 15% of its closest American peer, Amazon.com.’

The magazine reports that adding in its core Chinese e-commerce unit, its cloud computing and logistics businesses, and a stake in Ant Financial, ‘the sum of the company’s parts comes to about $130 a share, nearly double the current stock price, according to analysts at China Merchants Securities in Hong Kong’.

But here’s the catch. Stack it up against its nearest e-commerce peers such as Amazon and Mercado Libre in Latin America, and Alibaba’s growth rates for sales and earnings look a bit meagre. 

And what’s true for Alibaba is true for China. There are a few excellent reasons why Alibaba and Chinese equities generally are cheap but the biggest is because earnings growth is lacklustre. SocGen’s Asia analysts recently observed that China 2024 EPS growth estimates were still being revised down and ‘we have yet to see an end to the earnings downgrade cycle’.

To be fair, the macroeconomic turning may be coming, at which point we might see a massive spike in earnings growth but, until there is evidence of that, investors like me will be cautious.

In the firing line

Bloomberg’s Authers summed up concerns about corporate governance: ‘Beijing is now turning attention to reducing the size and power of the financial sector. Marko Papic of Clocktower Group pointed to Tuesday’s high-level work conference on financial services and said it was “widely perceived by investors as a prelude to a comprehensive crackdown on the financial industry”. 

‘He pointed out that the conference concluded that regulators “must severely punish corruption and strictly prevent moral hazard while resolving financial risks” and that the industry must “prioritise righteousness over profits”.’

If that last line doesn’t say it all, I don’t know what else to offer.

There are, of course, some strategies to work around the governance and economic issues, such as concentrating on the big Chinese dividend payers that proved stable during the selloff. The drawback is that most of the China investment trusts tend to have a strong growth and small-cap bias, such as Fidelity Special Situations (FCSS ), which I have owned on and off over the years. The logic here is small-cap stocks can escape political attention.

One of my concerns for Alibaba is that it’s so big, it is nearly always in the firing line of some communist-inspired policy nexus, be it labour practices, too much gaming, not enough righteousness, etc.

Even if the company adopts a back-to-basics view and focuses exclusively on the net cash bottom line and churns out a pile of cash, the state will be very keen to make sure it ‘invests’ that money in strategic imperatives that might not make sense for the shareholder.

Small isn’t necessarily beautiful

Smaller companies by contrast can get on with real-world concerns. The hitch is that it hasn’t helped the recent returns of funds like Fidelity China. According to Deutsche Numis, in share price terms the fund is down 31.2% over one year and 49% over three years.

Only over five years do shareholders get a total gain of 7.7%, while over 10 years returns add up to 106.9%.

By contrast, the MSCI China index has fallen 29% over one year, with 50% and 24.8% declines over three and five years. Over 10 years, however, the benchmark is up 32%.

A chart of Fidelity China against the CSI 300 shows that, except for the pandemic years, the fund moved in step with large-cap equities.

To return to my opening question – are Chinese equities cheap? Yes. Might they get less cheap if macroeconomic stabilisers kick in? Yes. But are they investable? I just can’t decide.

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