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China's equities seen overtaking India's in 2014

Chinese shares may be poised to become an unlikely star of Asian emerging markets in 2014, outshining India, thanks to cheap valuations and optimism about reforms.

Investors have been underweight China for years.

China-focused equity funds saw some net inflows in November, when the ruling Communist Party announced plans for far-reaching economic and social reforms, and analysts said once the government starts following through on those plans it would trigger a flood of money.

Foreigners have bought a net $18.8 billion worth of Indian shares this year, according to the market regulator's data.

A woman watches the electronic board at a stock exchange hall in Huaibei, China.
ChinaFotoPress | Getty Images
A woman watches the electronic board at a stock exchange hall in Huaibei, China.

Official statistics are not published for China, but data from fund tracker EPFR shows a net $5.5 billion outflows for the year to Dec. 11 for China-focused equity funds.

(Read more: Americans see China's dominance)

At 9.3 times forward 12-month earnings, the MSCI China is trading at a chunky discount to its 10-year median and at its widest gap to the MSCI Asia ex-Japan since the 2008 financial crisis.

And the Chinese market is trading at a 40 percent discount to MSCI India on a forward price-to-earnings basis, according to Thomson Reuters I/B/E/S data.

In contrast, benchmark indexes in India have hit record highs and valuations are on par with 10-year averages.

(Read more: Tesla's plan for China)

Besides looking expensive, Indian shares could also be vulnerable to shocks that could come from the Federal Reserve winding down its stimulus, current account problems, and a general election due by May next year.

At the very least, investors look unwilling to add more Indian risk and will look to make fresh allocations next year in other markets, with China firmly on their radar.

"Overall, we believe Chinese equities are just too cheap to be ignored by investors in 2014,'' said Desmond Tjiang, Greater China and Hong Kong equities portfolio manager at Pinebridge Investments in Hong Kong.

"Despite reforms and the broad economic slowdown, there are still a lot of industries such as mass consumption, e-commerce and environment-related sectors that should continue to grow exponentially in the coming years.''

(Read more: China to post best GDP reading of 2013)

Beijing last month unveiled a bold reform plan, including pledging to free up markets, in a bid to put the world's second-largest economy on a more stable footing.

The plan sparked a rally in Chinese stocks that saw the offshore Chinese market in Hong Kong gain more than 10 percent in four sessions, before leveling off.

Some brokers, such as CLSA, said the rally lacked conviction due to an absence of institutional investors. But while some may still be wary of a market that has been in a funk since 2007, there are signs things could be turning around.

In a Nov. 21 report, Goldman Sachs said funds focused on global emerging markets and Asia were underweight China by 290 and 582 basis points respectively, suggesting a return to equal weighting alone would trigger a powerful rally.

(Read more: Is inflation a new risk for China's economy?)

"India may have more upside potential in the short term because markets may rally into the elections due in May, but China represents better value in the middle term,'' said Angelo Corbetta, Pioneer Investments' London-based head of Asian equities.

Playing China Smart

But India's potential is starting to look stretched on valuations already. Information technology and pharmaceutical companies, which led stock indices to record highs last week, are expensive.

The MSCI India IT sub-index trades at 21 times earnings forecasts for the year ahead, well above the 12 times for the equivalent index for Asia-Pacific countries outside of Japan. The MSCI health care sub-index is starting to look similarly stretched.

In comparison, China Inc's earnings revision ratio—the pace of earning forecast upgrades against downgrades—has turned around, suggesting investors think Chinese companies' earnings prospects are improving.

(Read more: Yuan moves one step closer to global currency status)

"For three years, markets have been betting on a hard landing in China. It is time to unwind some of those bets,'' said the head of a Asian macro hedge fund in Hong Kong.

For the rally to last beyond early 2014, investors will expect clear steps to be taken to resolve Chinese banks' bad debt problems. They will also want to see how the reform drive will impact corporate margins and earnings, especially for giant state-owned firms.

"We will be looking for a dramatic improvement at the operating cash flow level at the next earnings. Most Chinese companies have negative working capital, which means they are subsidizing their clients,'' Pioneer's Corbetta said. "It's all about allocating capital more efficiently.''

(Read more: As China's foreign reserves surge, are currency wars back?)

If that happens, Chinese equities may well see a re-rating in the longer run.

"If China gets its reform right...we will move into an environment where we don't just buy the dip and sell the bounce, but you actually just buy the dip because the long-term trajectory is positive as opposed to flat to down,'' said Andrew Swan, Blackrock's head of Asian equities, told the Reuters Investment Summit in late November.

—By Reuters.

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