China’s Stocks Had a Rough 2021. Watch for a Turnaround in the Year of the Tiger.

Paradoxically, the worse the news on the economy front, the better it may be for investors. China’s crackdown last year on its property market has hobbled a go-to source of growth, and the mixture of Omicron and Beijing’s strict Covid-19 restrictions has curtailed economic activity further. Roughly a third of the economy is below the trend extrapolated from 2019 growth by Goldman Sachs
‘ estimates, and the International Monetary Fund cut its global economic growth outlook for this year by half a percentage point to 4.4%, in part because of China’s troubles.

China’s sluggish economy is troublesome for authorities, with a commission that oversees China’s police, prosecutors, and courts issuing a rare warning this month about the potential political and social ramifications of economic weakness, hinting at the risk of instability.

The desire for stability lowers the odds of further dramatic regulatory crackdowns this year, even as Beijing is likely to continue its regulatory drive. It also increases the likelihood of market-friendly stimulus measures in the near term to steady China’s economy.

The latest indication of this shift came last week as the People’s Bank of China cut its benchmark lending rates—in contrast to many of the world’s other central banks, including the Federal Reserve, which is poised to raise rates and reel in the stimulus that has propped up U.S. stocks. 

The divergence in policy should offer Chinese markets some support and plays into Chinese equities “likely transitioning into a ‘hope’ phase from ‘despair’ where an expansion in price-earnings ratios typically outweighs weak fundamental growth to drive strong gains, said Goldman Sachs Chief China equity strategist Kinger Lau in a recent note to clients. Indeed, the iShares MSCI China exchange-traded-fund (ticker: MCHI) is down just a fraction year-to-date, while the S&P 500 has lost 8.6%.

The shifting backdrop may not change the minds of a subset of investors who are turned off from Chinese investments amid human rights abuses toward the Uyghurs, increasing state intervention in the economy or continued U.S.-China tensions.

But a swath of investors see China much the way the heads of major global companies do. Even with growth slowing and an expanding list of concerns, the potential to make money in the world’s second-largest economy outweighs the price of sitting China out.

As Barron’s has written before, many professional investors have reduced holdings of U.S.-listed shares as the Securities and Exchange Commission moves toward delisting companies within a three-year window that don’t open their books wider. And they are looking for opportunities in China’s domestic companies, adding to Hong Kong-listed shares and focusing more on the opportunity in China’s onshore Shenzhen and Shanghai, or A-shares, market.

That trend is expected to continue as more Chinese companies follow the lead of Alibaba Group Holding (ticker: BABA), JD.com (JD) and NetEase (NTES) and others to list closer to home, especially as Beijing makes it easier for companies to do so by relaxing restrictions—and the successful Shanghai listing of China Mobile after it was booted off U.S. exchanges early last year confirms that companies can prosper without a U.S. listing.

As investors look to 2022, though, some of the internet heavyweights that have been a fixture in portfolios may cede some ground to other companies as China focuses on developing other areas of its economy. That’s not to say money managers are writing off heavyweights like Alibaba, Tencent, or Baidu (BIDU), but more volatility is expected as Beijing continues to rein in the sector and crafts regulations related to data. Plus, it’s not yet clear how rules will be implemented and the ultimate impact on business models.

For some value managers, valuations—with Alibaba trading at 14 times next year’s earnings and online search giant Baidu at under 19 times—are compelling enough to start nibbling on a subset of profitable and dominant internet heavyweights.

Though it could take as much as two years to get the full impact of the regulatory changes, Ginny Chong, head of Chinese equities at Mondrian, says companies like Alibaba and Baidu have the wherewithal to navigate the transition. Baidu, for example, has 30% to 40% of its market cap, in investments and cash and its foot in businesses Beijing is focused on bolstering, like autonomous driving, artificial intelligence and cloud.

But valuations are still not enticing enough for others like Harding Loevner Emerging Markets Equity co-manager Pradipta Chakrabortty to add to holdings like Alibaba and Tencent Holdings
(700.Hong Kong), though over the long run he sees them as winners even if their growth prospects are clipped by half.

“The opportunity set is morphing away from the winners of the last 10 years and the online businesses, e-commerce companies and gaming,” says Chakrabortty, who is increasingly gravitating toward the smaller- and medium-sized enterprises that Beijing is looking to bolster as it focuses on becoming less reliant on foreign suppliers and building its technological capabilities, as well as expanding its middle-class in smaller cities.

Many of the beneficiaries of this shift are in China’s domestic, or A-shares market, which eked out a 3.5% gain in 2021 even as other Chinese stocks tumbled, and was home to a third of the 50 best-performing stocks in the MSCI All-Country World index, according to Goldman Sachs.  

Part of the draw is its makeup. The Hong Kong market is dominated by consumer discretionary companies, which make up 30% of the index. Communications and financials make up another third. Meanwhile, the MSCI China A-Shares index that tracks stocks on the Shanghai and Shenzhen has a bigger weighting to the types of businesses that stand to benefit from Beijing’s shifting priorities, including industrials, healthcare and information technology.

Volatility is par for the course among these onshore companies, a reason Chakrabortty sticks with companies with strong balance sheets and dominant positions in niche areas buffeted by strong investment in research and development. That includes Zheijiang Sanhua Intelligent Controls (2050.China), which sells its thermal management components to appliance and car makers, including Tesla , or Sangfor Technologies (300454.China), which benefits as the government encourages spending on cybersecurity and cloud.

Mondrian’s Chong is also digging into other sectors like financials and healthcare hit recently by regulation but that can also benefit from China’s shifting priorities. Beijing’s efforts to clean up its property sector and nudge households to park their money elsewhere bodes well for China Merchants Bank (3968.Hong Kong), which sells an array of wealth management products, as well as insurer Ping An Insurance (2318.Hong Kong), which is restructuring toward long-term life insurance products, Chong says.

For U.S. retail investors looking to tap China these days, a mutual fund is the best option. But here too, taking a broader approach may be better than focusing simply on an A-shares fund, in part because the A-shares market is notoriously volatile. 

“A single country emerging markets fund is like owning a stock, owning an A-shares focused fund is like owning an aggressive stock,” says Morningstar senior manager research analyst William Rocco says. “It’s trendy now for a variety of reasons. You have to be careful.”

The better option may be sticking with emerging market funds that have the flexibility to go wherever the best opportunities pop up. Andrew Mattock, lead manager of the Matthews China fund (MCHFX), which has returned an average annual 15% over the past five years, is trying to strike a balance in holdings.

The fund’s A-shares weighting rose through the past year to 44% of the portfolio from 37% at the beginning of the year, but valuations now appear stretched. More recently, Mattock has picked up shares of beaten up Hong Kong-listed shares—including of profitable and dominant internet platform companies—as well as added to financials like exchanges, brokerages and banks that benefit from Beijing’s efforts to reform its capital markets but have been ignored by investors.

For those looking for a more diversified emerging markets fund, here are two funds with strong track records, relatively low expense ratios and more allocated to China—and A-shares—than peers:  The BlackRock Emerging Markets fund (MDDCX), a high conviction strategy run out of a Hong Kong that had roughly 8% of its assets in A-shares, and the BNY Mellon Global Emerging Markets fund (DGEAX), which has been increasing its allocation to China over the last three to six months—most recently to 35%.

The BNY Mellon Global Emerging Markets fund co-manager Ian Smith looks for quality-oriented “compounders,” well-run businesses often in industries with a long runway for growth, a reason they aren’t as sensitive to near-term valuations as other managers. Lately, Smith is finding more of the businesses with policy support from Beijing in the onshore A-shares market, with those companies accounting for 14% of assets, among the highest allocations to A-shares among diversified emerging market equity funds, according to Morningstar.

One theme prevalent through the portfolio is “upgrade China.” That includes early opportunities in enterprise software as service companies tap into the digitization of corporate China. It’s also companies tied to China’s energy transition as it moves away from getting 60% of its power generation from coal toward renewables. Also in this group: companies that provide software to upgrade power grids and power solar and electric vehicles. Each of these companies represent reliable levels of growth ahead, Smith says.

Smith and his team are evaluating opportunities among battered internet platform companies, especially as regulation could chip away at their competitive advantage when new rivals are encroaching, and a weaker economy slows consumer spending.

“On valuation grounds, they look very reasonable. But from a risk-reward standpoint, it’s not as if the view has improved much through this underperformance,” Smith says. “What we want to focus now is on how they can adapt to the new era.”

Investors hoping to get ahead in this new era may want to seek out managers that can channel the tiger and his agility as China continues its transformation.

Corrections & Amplifications

Andrew Mattock is lead manager of the Matthews China fund. An earlier version of this article incorrectly identified his title as co-manager.

Write to Reshma Kapadia at [email protected]