The MSCI China Index is roaring this year, up 49 percent. Yet it has a long history of booms and busts. It soared almost 150 percent from 2006 through 2007, then fell 51 percent in the 2008 crash, then recovered 68 percent in 2009–2010, only to fall 18.2 percent in 2011. Since then, it's bounced around like a yo-yo with little to show for investors until now.
Is it too late to dive in? Perhaps not. China-focused fund managers say this rally's different —famous last words on Wall Street. But it seems like this time they have a legitimate case.
The Chinese stock market has evolved well beyond a much more narrow group of first-generation industrials, and that makes comparisons to previous busts and previous valuations less relevant than they would normally be in more developed nations, like the United States. Even if the Chinese stock market is due for a breather, the longer-term trend should be up for many of the leading stocks, experts say.
"In 2004 virtually nothing of China's mainland companies were listed in Hong Kong," says Andrew Mattock, lead manager of the $782 million Matthews China Fund (MCHFX), up 52 percent this year through October 12, according to Morningstar. Before that, the stocks that investors were buying were Hong Kong-oriented companies. In 2005 mainland China started listing companies, and those companies were very much in tune with what the economic development was at the time — mainly export oriented, industrial and infrastructure companies.
Those old economy sectors suffered from overcapacity and fell hard in the subsequent 2008 and 2011 crashes. Since then, China's government has dialed back on its industrial capacity. "The government has put in administrative measures at banks to restrict lending to excess capacity industries — steel, cement, aluminum, copper and the construction," says Edmund Harriss, manager of the Guinness Atkinson China & Hong Kong Fund (ICHKX). "They have also been active in cutting back excess capacity at state-owned enterprises that are producing inefficiently, which are being made to shut down. There has been measurable improvement in that capacity, enough to bring about a recovery in pricing power in these sectors."
Simultaneously, a new wave of consumer and domestic-oriented companies has come to dominate China's equities market. In particular, stocks of internet companies that cater to China's burgeoning middle class, which grew from 5 million people in 2000 to 225 million in 2016, according to consulting firm McKinsey, have exploded. Social media giant Tencent, China's version of Facebook; and e-commerce powerhouse Alibaba Group, China's version of Amazon, are up 84.8 percent and 105.6 percent, respectively, year-to-date through Oct. 13. Those two stocks now account for almost 30 percent of the iShares MSCI China ETF (MCHI), which tracks the MSCI China Index.
"These internet companies have facilitated the roll-out of lots of other types of businesses in China — from gaming to payment systems, online money market funds and streaming entertainment," says Mattock. "What investors are buying today at a stock level in China is a lot more diversified."
There are three times as many companies, and the market capitalization has gone from $2 trillion in 2004 to $12 trillion.
"The companies driving the stock market earnings now are not the cyclical industrial companies of the past. So that means a lot better cycle in terms of earnings. I don't think we'll get the same uplift in corporate earnings next year as this year, but I still think we'll see healthy profitability growth," Mattock said.
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That said, the Matthews Asia manager is cautious in the short-term, but enthusiastic longer-term about Tencent and Alibaba. "Internet stocks are at fair value on a 12-month review," he said. "But the growth drivers behind these companies are so diversified that on a three- to five-year view, there's not much downside to them." He added, "Seventy-five percent of all time spent on the Chinese internet is via a Tencent application."
The scale of China's internet potential is enormous, according to Mattock, who claims that "269 million people watched the NBA final last year in China via Tencent's streaming service. In the U.S. it was 30 million."
Valuations are better in sectors outside the big tech names. Chinese stocks in the MSCI China Index as a whole have a 2018 forward price/earnings ratio of 12.7. "If you take out technology from the mix, they're at 8 times," Harriss said. Tencent and Alibaba have forward price-to-earnings ratios of 36x and 41x, respectively, according to Morningstar. The S&P 500's P/E ratio is 20.6.
Harriss equal-weights his portfolio and pays attention to valuations, so his 2.9 percent Tencent position has caused his fund to lag the index with a 40 percent return this year. However, with holdings in cheap financial sector plays like China Merchants Bank, China Construction Bank and China Minsheng Bank — P/E ratios of 9.7, 6.2 and 4.7, respectively — Harriss might have the edge going forward as China finishes cleaning up its act in its old economy sectors.
Growth outside the two tech giants is sought by funds like the Oberweis China Opportunities (OBCHX), which is up 54.6 percent this year. While it holds Tencent and Alibaba, it also delves into rapidly growing small- and mid-cap names in sectors that reflect the growing middle class, like education companies. TAL Education Group and New Oriental Education & Technology Group (EDU) have soared 198.2 percent and 116.1 percent in 2017.
Whatever you do, don't buy leveraged China ETFs like Direxion Daily FTSE China Bull 3X (YINN) and Direxion Daily CSI China Internet Bull 2X Shares (CWEB). The 118 percent return on YINN year-to-date might make an investor happy today, but China's market is hot enough this year. You don't want two to three times the losses in case this time it doesn't turn out any different than in the past.
— By Lewis Braham, special to CNBC.com