Why China-Related Stocks Are Looking Like Bargains

Investors watch the electronic board at a stock exchange hall in Huaibei, China.
ChinaFotoPress | Getty Images
Investors watch the electronic board at a stock exchange hall in Huaibei, China.

China could be closing a rough year in at least a somewhat better light, as investors are beginning to buy into the theme that markets there may be nearing a bottom.

Stocks with high exposure to China got clobbered this year as investors worried that the world's primary engine of growth was slowing and likely to drag down everyone else.

But with a huge bite already out of the country's stock indexes, sentiment is taking root that the nation could be worth another look, at least as a value play.

"Long-term, whether the actual economy in China is growing 3, 4, 5, 6 or 7 percent, all of these are faster than the U.S., Europe, and Japan are growing," Adam Parker, chief market strategist at Morgan Stanley, said in a note. "So, our judgment is that negativity on China is quite high and that there is potential for more optimistic news on the policy front over the next few months."

Investors got some mildly positive news Monday when China's Purchase Managers Index broached the critical 50 barrier, registering a 50.5 that signals expansion rather than contraction. It was the first time in more than a year that the PMI crossed that line. (Read More: Factory Surveys Show China Reviving, Global Rebound Fragile)

As production has slumped, Chinese stocks have taken a hit.

The Shanghai Composite Index has gotten pummeled, dropping about 17 percent over the past year. A separate index which measures companies incorporated in China that trade on the Hong Kong exchange, called H-shares, has fared better, gaining 1 percent in the previous 12-month period.

Bullishness towards China is coming less from a feeling that things are getting back to normal and more from a simple valuation call. Investors think the country is making at least an intermediate bottom that is posing a buying opportunity.

"We are 'chicken China' bulls. We don't have enough confidence in a fundamental recovery to jump in and buy beaten-down materials and metals. It is just too far out on the efficient frontier for us now," Parker said. "This is more of a trading and sentiment call about what is discounted, not a China bottom call. If it turns out to be both, great."

From a company perspective, Parker said U.S. stocks with China exposure are collectively near five-year lows in terms of price to forward earnings and "discounted pretty materially."

Specifically, he recommends Danaher, Agilent Technologies, United Technologies, Emerson Electric and Caterpillar.

Positive sentiment is a risky bet, as Parker notes in his analysis where he says he will reverse course should any of his picks make sharp moves higher.

Hedge fund titan Jim Chanos has been the most notorious China bear, asserting that the country has been overbuilt and is unable to sustain growth. He also has said Chinese companies aren't being honest with their accounting. (Read More: China's a 'Roach Motel'; Don't Trust the Numbers: Chanos)

Indeed, at least some of the hope of a resurgence is pinned on the new Chinese leadership and its pledges to reform the way business is conducted.

"The new leaders are effectively in full control from now on, which shall improve policy delivery," Citigroup said in an analysis. "We expect the new leaders to carry out gradualist reforms to facilitate more balanced and sustainable growth."

Growth measures will be targeted toward industrialization, digitalization, urbanization and agricultural modernization.

"Barriers for long-term capital flows will likely be further reduced," Citi said. "We may see more tax cuts for small business, introduction of (a value-added tax) for service industries in more regions, and expansion of the property tax reform."

While China has earned much of the skepticism it has garnered from outside investors, economists are getting more optimistic that the growth engine can be restarted and that business practices will be improved.

The Organization for Economic Cooperation and Development recently predicted that growth in gross domestic product would hit 8.5 percent in 2013 and 8.9 percent in 2014.

"The organization rightly points out Beijing has met with success in curbing inflation and getting property prices under control, and it expects a revival in domestic demand," said Jerry Webman, chief economist at Oppenheimer Funds.

"Skeptics may wonder about the effects of weak demand for Chinese exports" especially in Europe, he added, "but it's worth remembering that exports comprise only about 30 percent of Chinese GDP, and that the country is actively working toward the development of a more consumption driven growth model."