2023-09-18 06:16:59 ET
Summary
- Chinese stocks have been a growth story, but they have also been characterized by significant risks that investors sometimes ignore, leading to a cyclical pattern of enthusiasm and disappointment.
- iShares China Large-Cap ETF aims to provide diversified exposure to China's largest and most established companies. However, its performance has been mixed, with negative ten-year returns and significant.
- Risks in investing in Chinese stocks include regulatory and political risks, a lack of transparency in financial reporting, and a lack of shareholder rights.
- The above risks have been joined by additional concerns, including China's substantial debt problem and the overhang related to China's Taiwan interests.
- The risks associated with investing in Chinese stocks outweigh the potential benefits. While the sector may appear cheap presently, the persistent and growing risks make it a less attractive investment option. There are other areas of the market that offer better risk-adjusted returns.
China has been the biggest growth story for the last few decades and the growth was also accompanied by a lot of promise. However, not all growth translates to expected returns and returns from the Chinese stock market are a prime example in this regard. In my opinion, the risks involved from investing in China have always been a huge factor in this story which has seen its fair share of ups and downs in the last two decades. When investing in China, these risks have always been present yet investors continue to ignore them only to be reminded of these risks later on. On a high level, this is how it looks.
1. The sector shows promise and looks cheap
2. Investors get excited and flock to this stock market
3. Investors are reminded of the risks which makes the sector cheaper again
4. The cycle would repeat with another generation of investors
In my write-up, we will examine:
- The promised growth story from China
- The underperformance of the Chinese stock market by viewing iShares China Large-Cap ETF ( FXI )
- Risks that have always been present and additional risks that are present now that would again remind investors why this sector can be uninvestable
ETF Dive
The iShares China Large-Cap ETF is an exchange-traded fund that aims to track the performance of the FTSE China 50 Index. FXI provides investors with exposure to some of the largest and most established Chinese companies, primarily those listed on the Hong Kong Stock Exchange and other international exchanges. These companies are typically leaders in the financial, technology, and consumer goods sectors.
Diversified Exposure: FXI offers investors diversified exposure to China's equity markets by investing in a basket of large-cap Chinese stocks by providing access to 50 of the largest Chinese stocks in a single fund and the top 20 names account for more than 80% of the fund.
Characteristics:
The fund has net assets of approximately $5.2B, was conceived in late 2004, and currently has a management fee of 0.74%. It boasts a trailing 12M yield 2.46% and has a P/B ratio of 1.4x and an overall PE ratio of 11.3x. The top sectors account for more than 50% of the funds' allocation.
The story then
Looking at the performance of this ETF is a prime example of when narratives and hype do not always translate into returns. Ten-year returns of the ETF have been negative and have greatly underperformed the S&P 500. The picture looks better when you zoom out and consider the returns since inception (132% versus 467%).
Barring the last few years the China story has been remarkable as presented by many investing outlets.
Economic Reforms: China initiated economic reforms and opened up its economy in the late 1970s under Deng Xiaoping. By the early 2000s, these reforms were well underway, fostering a more market-oriented economy with elements of capitalism.
Rapid Industrialization: China became known as the "world's factory" due to its massive manufacturing capabilities. Low labor costs, a vast workforce, and a focus on export-oriented production made China a global manufacturing hub. This also resulted in trade consistent trade surpluses which contributed to its economic growth.
Infrastructure Development: China invested heavily in infrastructure projects, including high-speed rail, highways, ports, and airports. These investments supported economic growth and enhanced connectivity.
Urbanization: Millions of rural Chinese citizens moved to cities in search of better economic opportunities. This urbanization process fueled consumption, real estate development, and the growth of the middle class.
The above factors were further supported by foreign investment with companies establishing a presence in the country to access its large consumer base and its low-cost production. Investments in technology led to China developing world-class products, especially in areas like e-commerce and telecommunication. All of this transformed the country completely. The argument was that the ongoing transformation would accordingly benefit investors willing to participate in its stock market.
The risks then
Regulatory and Political Risk: While China introduced economic reforms, its political system remained largely centralized under the leadership of the Chinese Communist Party ((CCP)). The CCP maintained a monopoly on political power, and its leadership structure has not seen significant changes. Its political system remains authoritarian.
Lack of Transparency: Chinese companies listed on foreign stock exchanges, had lower transparency and disclosure standards compared to Western counterparts. Lower transparency and disclosure standards mean concerns about the accuracy of the financial statements in extreme case leads to allegations of fraudulent accounting practices.
Lack of rights: Chinese stocks are listed as ADRs (American Depository Receipts) and offer exposure to Chinese companies but work differently for regular shareholders because of their structure. Investors who buy shares in Chinese stocks do not technically have any ownership of the underlying business whatsoever, meaning no rights as a shareholder. This risk combined with the regulatory crackdowns can lead to significant stock price declines.
Additional risks now
None of the risks discussed in the previous section have disappeared. But now there are additional risks involved.
Debt Trouble: Domestically, China is grappling with an extensive debt problem, including debts from local governments, off-the-books financial entities, and real estate developers, although precise figures are elusive. JPMorgan Chase researchers recently estimated that China's overall debt, spanning households, businesses, and the government, has reached 282 percent of its annual economic output. This surpasses the debt-to-GDP ratios of developed economies and presents a challenge due to the rapid accumulation of debt relative to China's economic size over the past 15 years.
The biggest challenge is in managing its $9T off-balance-sheet local government debt, without resorting to large-scale bailouts. The provinces and cities responsible for this debt must reduce their spending and restructure their debts while avoiding a significant negative impact on economic growth. If they fail, it could lead to a prolonged economic downturn in the world's second-largest economy.
The heart of this issue lies in local government financing vehicles (LGFVs), which were set up to borrow on behalf of provinces and cities but not explicitly in their name. The Chinese government aimed to transform these entities into profitable businesses so that they could cover the interest on their debts without government support. However, reports suggest that this transformation is not working effectively, especially in poorer inland regions.
The potential failure of local government debt restructuring could have significant consequences, impacting China's economic growth and creating instability in its financial system, as LGFV bonds account for a substantial portion of the country's onshore corporate debt market. Market forces have also exacerbated the situation, with bond buyers demanding higher interest rates and shorter maturities for LGFVs in poorer areas, increasing debt service costs and refinancing pressures.
The success or failure of local government debt restructuring will be a crucial variable impacting China's economic growth in the near future.
Geopolitical Trouble: Tensions between China and the United States can create geopolitical risks that affect Chinese ADRs. Trade disputes, sanctions, or export restrictions can disrupt companies' operations and stock prices. There is also a big overhang from China's interests in Taiwan and every passing day sees more grim news in relation to this. The ultimate goal of China is its reunification with Taiwan and presently the chance of this being a peaceful integration is far too low. The fallout of this integration can potentially have a far-reaching impact on the stock market as a whole and disproportionately affect Chinese stocks.
Final Call
I rate this ETF as a Sell. In my opinion, the risks of being invested in this ETF far outweigh the benefits. This does not mean that this sector will not see a rise in the coming years. The ETF has seen a 33% correction in the last five years and looks "cheap" again. This may attract yet another batch of investors who see potential in its stock market. But we have seen this story before. The risks in China's stock market are part of its system and cannot be separated from the investment. In fact, more risks have been added to this pile in the last few years and there are other areas of the market that offer superior returns for the risks.
For further details see:
FXI: Growth And Promise Do Not Always Translate To Returns