NTES - Is MCHI ETF Truly Undervalued? Here Is Why I Believe It Is

2024-01-15 10:41:02 ET

Summary

• The iShares MSCI China ETF holds undervalued companies with strong fundamentals, excellent growth prospects, and an average P/E of 11.46.
• It presents good growth margins compared to the S&P 500, which has a P/E of 24.05 and is considered overvalued according to Peter Lynch's "rule of 20".
• The downturn of recent years presents an opportunity, and the overexposure of funds to short positions could act as a catalyst for the resurgence of the Chinese index.
• I remain bullish, even though the business of Tencent and NetEase risks compromising the growth prospects of the entire ETF.

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The downturns of 2022 and 2023, triggered by years complex in terms of economic and geopolitical aspects, have instilled fear in Asian market investors and simultaneously captured the attention of analysts engaged in the vigorous search for companies capable of adding alpha to their portfolios. Stock Picking in the Chinese stock market, aimed at identifying undervalued companies, indeed seems to offer numerous insights from a fundamental perspective for value investors. This is considering the significant drops over recent years, against, in many cases, not only solid but even growing fundamentals.

Here, the classic iShares MSCI China ETF (MCHI) undoubtedly becomes a benchmark for investors interested in passive investment solutions. In my opinion, a study of the composition of its main holdings reveals significant discounts, which could whet investors' appetite in 2024, a year when "bargains" are certainly not the norm in the West. This, I believe, could bestow significant alpha on the aforementioned ETF.

Chinese Stocks Are Too Attractively Priced To Be Ignored For Long

Breaking down the index, of the 766 companies included in the ETF, a significant portion of its liquidity, approximately 41%, is allocated in the top 10 holdings. This summary table helps to understand the fundamental structure of these top 10 investments of the fund.

At a cursory glance, an average P/E ratio of 16.85 is immediately noticeable, heavily skewed by Meituan . The estimated earnings growth for China, or at least for the top 10 capitalizations of the ETF's benchmark, the MSCI China Index, is around 13%. Thus, we are talking about companies that, according to the accounts reported, and we all know why often it's better not to trust Chinese accounts , have a market price that, according to the MSCI China Index, has contracted by 60% from its highs, comprised of companies with distinctly positive operating margins and prospects of earnings growth exceeding 10%. In my opinion, there are two options: either we are facing a clear failure of fundamental valuation models, or over time, Chinese stocks will return to discount noteworthy multiples, even if only due to speculative manias. Growth expectations rise when referring to the consumer discretionary sector, which accounts for about 29% of the benchmark's stock composition.

The crash of Chinese stocks in 2023 is due to a contraction in the level of domestic consumption, beginning with a stagnation in the real estate market. For this reason, an economic stabilization of the country, perhaps through various measures implemented by the government , via the PBOC , could positively impact the fundamentals of these companies, already quite battered by the difficult past year.

The S&P 500 Is Too Expensive; Soon, Attention Will Likely Turn Towards New Markets

The appreciation of the iShares MSCI China UCITS ETF could therefore occur for technical reasons:

• A massive shift of capital towards companies with high alpha, as opposed to companies that have already grown substantially and have high, less attractive multiples.

• A speculative wave that sweeps away short positions.

(Often, one does not exclude the other.)

Expanding the range of observation, the entire iShares MSCI China UCITS ETF , which represents the stock market performance of the world's second-largest economy, has a P/E Ratio of 11.46 and a P/B Ratio of 1.43. The iShares Core S&P 500 UCITS ETF has a P/E of 24.05 and a P/B of 4.41. According to Peter Lynch's Rule, commonly referred to as " the rule of 20 ," the P/E of the S&P 500 added to the Year-over-Year CPI has reached the level of 35X. Historically, this has signaled the beginning of "lost decades." In these times, while gold appreciates and the dollar depreciates, the market looks to fixed-income securities. However, in a context of decreasing interest rates, Chinese stocks, which clearly present a positive alpha, in my opinion, could benefit from a strong influx of capital.

According to research reported by Reuters , short positions are currently near their highs, with the peak reached in September, as per a Morgan Stanley report. The value of short-term interests on these stocks rose to 2.1 billion dollars as of September 22. Essentially, also from a technical perspective, in my opinion, a strong negative extreme has been reached, which could inevitably be balanced out by the typical cyclicality of the market.

Tencent And The Draft Gaming Legislation Represent A Concerning Risk

It's clear to see how the most influential holding in the ETF, accounting for a significant 13% of the composition, is Tencent (TCEHY), which speaks volumes about the reason for the sharp contraction in the benchmark MSCI China Index. Tencent is experiencing a decline in the stock market due to a draft published some weeks ago by the Chinese National Press and Publication Administration. Another high capitalization stock, which is particularly discounted and whose price has reacted negatively to the sharing of the Chinese draft law, is NetEase ( NTES), another entity significantly influencing the ETF's performance.

Both companies show relatively low P/E ratios compared to their fundamentals, due to the drop in stock prices, with the market anticipating decreases in earnings values in the coming years with the approval of the draft law. However, according to data from Seeking Alpha, the earnings estimates for 2024 remain positive and above average.

A crucial determining factor is therefore the impact that the approval of the draft law titled "Method of Managing Online Games - Draft for Consultation" could have. I have read and interpreted the document released by the National Press and Publication Administration, and essentially, the Chinese government is simply promoting the protection of minors and the promotion of healthy cultural content, referring to the territory of the People's Republic of China.

Tencent generated over a fifth of its third-quarter revenue from domestic online games, while NetEase accounted for 80% . Therefore, if two of the top 10 capitalizations in the index show a business almost entirely at risk, the growth of the ETF's price could be hindered.

Certainly, if you are interested in understanding how this does not deeply affect the value of the two companies, this article might be of interest to you.

I Remain Bullish On China, And Here's Why

In conclusion, I remain bullish on the Chinese stock sector represented by the MSCI China Index and on the ETF that uses it as a benchmark, the iShares MSCI China UCITS ETF. This bullish stance is largely due to the substantial hidden value present in the vast majority of the companies that comprise it, characterized by contained multiples, strong growth prospects, and significant potential for geographic rotation. The current overexposure to short positions could, in this case, play in favor of a rebound in the Chinese stock sector, potentially acting as a catalyst for a new period of rallies, which, as shown by historical series, remains very intriguing.

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