The bad news does not seem to stop out of China these days, with property developers in deep trouble and a general economic malaise that is leading the country to experience deflation. People were predicting a vigorous ‘V’ shaped recovery that wasn’t.
While American tech companies have been brought back to life by the market, recording eye-watering results this year, their Chinese counterparts have languished:
Chinese stocks have an implicit political risk factor which was never really priced correctly by the market until Jack Ma’s ill-fated attack of the Chinese system. That moment marked the beginning of a substantial crack-down on Chinese tech companies, which affected both earnings as well as P/E ratios.
The China Fund (NYSE:CHN) is a closed-end fund focused on Chinese equities. The vehicle does a good job in aggregating both Chinese ADRs as well as ‘A-shares’ to provide investors with exposure to the jurisdiction. In this article, we are going to explore the macro factors driving returns for Chinese stocks and detail why we believe now is a good time to start layering in exposure via CHN.
Buy an investment when values are low
The cornerstone of successful investing is ‘buy low, sell high’. This syntagm is best viewed via valuation metrics rather than pure price levels. The political crackdown on Chinese tech in the past few years, coupled with the sluggish post-Covid economic recovery, has resulted in very depressed valuation levels for Chinese equities when compared to American counterparts:
JPMorgan Asset Management is adding more Chinese shares to its portfolio on bets that the market’s inexpensive valuation and the government’s support for the economy will bolster returns. Invesco Asset Management Ltd. is overweight the stocks, and favors top tech names such as Alibaba Group Holding Ltd. and Tencent Holdings Ltd.
Let us have a closer look at one of the companies mentioned above, namely Alibaba, which is a CHN portfolio holding. BABA trades with a forward P/E of only 11x, whereas its American counterpart Amazon trades at an equivalent forward P/E in excess of 60x. BABA is not a Utilities company, but a Chinese Tech/Commerce behemoth that will see plenty of growth in the future. As a reminder, the entire S&P 500 is now trading at a 19x P/E ratio as a comparison.
Can BABA stay cheap via its P/E ratio? Sure. Are the macro factors that drove the de-rating changing? You bet.
With yet new sanctions from the U.S. government on China tech investments, the Chinese government is now rapidly realizing that it needs to foster its own intellectual capital development, and that translates into greater support for private company innovation and development.
The government is taking steps to flag its new intentions via communiques and conferences:
The Politburo acknowledged that China’s post-COVID economic recovery had been “torturous,” and declared that the Party would be taking steps to “promote private investment” and “invigorate capital markets and boost investor confidence.” The Party leaders said they want to support “healthy and sustainable development of platform companies,” and “encourage enterprises to dare to venture, dare to invest, dare to take risks, and actively create markets.”
Source: Andy Rothman, Investment Strategist
Let us translate that for you in English – the Chinese economy is experiencing a pronounced slow-down, the U.S. government is restricting investments in China’s development of cutting-edge tech solutions, and as a result of those two factors the Chinese government is realizing it needs its domestic private enterprises to pick up the slack.
The net result is a loosening of prior restrictions and crack-downs in a bid to stimulate growth and job creation. This will ultimately translate into higher P/E ratios for CHN portfolio companies.
Michael Burry of the ‘Big Short’ is long
Michael Burry famously bet against the housing market during the 2008-2009 Great Financial Crisis, and now runs his own hedge fund. As of the latest 13-F report, he is long two of the main holdings in CHN:
Michael Burry, the money manager made famous in The Big Short, now has a Big Long when it comes to China. He boosted his bullish bets on e-commerce giants JD.com Inc. and Alibaba Group Holding Ltd., even as other hedge funds cooled on the nation’s reopening trades. The two stocks have become the largest holdings of his Scion Asset Management, accounting for 20% of his stock portfolio.
We like Michael Burry because he is a contrarian investor that does not go with the flow. He side-stepped most of the 2022 market losses by going mostly into cash by August 2022, and now he is taking yet another contrarian bet on China.
Retail investors would be well served by following the likes of Michael Burry rather than TV personalities like Jim Cramer who usually peddle the latest and greatest, but in reality, represent an inverse signal.
The fund takes a fairly concentrated position in its top holdings:
We can see how the Top 10 names here account for over 47% of the portfolio. Alibaba and Tencent are the top holdings, with Chinese Tech and Commerce names the most allocated ones here.
From a structural standpoint, the CEF does a good job of having a nice mix:
Please remember that a year back the market was very concerned about the de-listing of Chinese ADRs listed in the U.S. This CEF does a good job of holding Hong Kong listed shares, ‘A-Shares’ (i.e., onshore listed equities), and ADRs. We like this structural feature a lot because it hedges away de-listing risks.
The CEF is a nice play on China’s recovery, staying away from ‘problem’ sectors such as Real Estate:
The portfolio construction is robust, and addresses the correct macro themes present in the jurisdiction at the moment, in our opinion.
- AUM: $0.12 billion
- Sharpe Ratio: -0.21 (3Y)
- Std. Deviation: 31.17 (3Y)
- Yield: 5.7%
- Premium/Discount to NAV: -14%
- Z-Stat: -0.5
- Leverage Ratio: 2%
- Composition: Chinese Equities
- Duration: n/a
- Expense Ratio: 1.54%
Premium/Discount to NAV
CHN is currently trading at a large discount to NAV:
Historically, we are towards the bottom end of the range here. Expect the fund to still trade at a discount down the road, but the discount to narrow. When the fund holdings will finally start trading at more normalized P/E ratios, and we see capital gains here, we expect a narrowing of the discount to -9%. That represents a +7% pick-up in total return from this structural CEF feature.
CHN is a closed-end fund. The CEF focuses on Chinese equities via an attractive portfolio that mixes Hong Kong listed shares with ‘A-shares’ and ADRs. This structural feature eliminates any de-listing risks.
The CEF’s top ten holdings account for almost 50% of the portfolio and represent top names in the Tech and Financials arena. The fund is overweight BABA and JD, two top picks by Michael Burry in his hedge fund.
The portfolio companies are undervalued in our opinion (via cyclical low P/E ratios), due to the Chinese government crack-down on private tech that started two years ago. With the economy in the doldrums and the U.S. ratcheting its pressure on Chinese tech investments, the Chinese government is now recognizing the need to foster a robust and innovative private Tech sector. In our opinion, this will translate into higher earnings and P/E ratios for CHN portfolio companies down the road.
CHN is a Buy for us here, but a retail investor needs to have a longer time horizon on this investment (at least an 18-month holding period here).