Why are Chinese stocks so unpopular?

Despite low valuations, there is little demand for Chinese stocks

Investors have undoubtedly been greatly disappointed by Chinese stocks. Over the past decade, the MSCI China index the standard benchmark for foreign investors has delivered a gross total return of 3.9 percent per year in sterling terms, barely half the already-disappointing return for the MSCI Emerging Markets ex China.

In the past, it was simple to claim that the market as a whole was bad due to the abundance of state-run companies that showed little regard for their minority shareholders. However, there were still great opportunities in consumer goods and technology. Making that argument, however, has become more difficult recently because many of the well-known private sector brands have underperformed over the previous five years.

Even so, the market appears cheap when viewed at face value because the MSCI China trades at ten times projected earnings. That undoubtedly indicates the existence of numerous subpar businesses, but for investors prepared to assume the risks, a low valuation at this level atones for many transgressions.

Two problems that floored Chinese stocks.

There are also plenty of risks.

A list of reasons to be concerned about China in the medium term can be compiled. The demographics show that the population will age more quickly than in nearly every other nation. Its territorial ambitions could eventually put it in direct confrontation with other nations, including the US, due to geopolitics, especially its insistence that Beijing should eventually rule Taiwan regardless of what the Taiwanese people think. Over the next ten years, investors will have legitimate concerns about these.

However, there are reasons to be pessimistic about practically any nation, and these have little to do with how badly the stock market and economy have done in recent years. Rather, we can identify two factors as the cause of the current issues.

The first is the real estate bubble popping. With both direct and indirect demand, real estate now accounts for a significant 25% of GDP and is a major driver of growth. It had also become excessively over-indebted, over-valued, and over-supplied. The main issue with the decision to end it by limiting developer lending is that the stricter regulations were implemented much too late. Policymakers made the same error that Western governments did in the 2000s: they allowed a real estate bubble to continue for an excessive amount of time, which made the problem's resolution even more difficult.

The second is the stifling of "animal spirits" in the economy through a number of other measures targeting the financial industry, tech companies, and a few smaller industries. Similar to real estate, there were frequently good reasons for government action. The giant tech firms had taken advantage of limited regulation and state influence (compared to many sectors of the economy) to build dominant positions and to try to extend this as widely as possible. There was a chance that established monopolies would hurt smaller companies and consumers.

The issue was that the crackdowns displayed every characteristic that investors find most concerning about China: abrupt changes to regulations, uncertainty about the boundaries, a lack of fundamental private property rights and the rule of law, and clear indications that private-sector businesses would be pushed aside in favor of state-owned businesses and increasingly co-opted to serve government interests rather than those of shareholders.

The Chinese government needs to do more.

No wonder that foreign investors became relentless sellers and talk of China being "uninvestable" was common. The slow performance of the Shanghai and Shenzhen stock exchanges indicated that domestic investors were also growing more pessimistic.

But last year, there were indications that the government had changed course and was now more pro-business and even pro-growth. There have been initiatives to increase local government funding, encourage the real estate industry, and increase consumption. Chinese shares surged as a result in September, but the gains have not been maintained. Investors feel the government hasnt done enough to turn around the economy and that it needs to do more, especially in real estate. Everyone agrees that the real estate industry is so powerful that it is impossible to restart growth without first stabilizing it. A reasonable amount of hope exists that the government will take further action. If it does, markets have a great chance to rise because China is so despised.

The China specialist sector is divided into three trusts. They have a lot of important assets in common, but they also feel very different, which is good for investors. The choice really comes down to strategy because all trade at comparable discounts of 10% to 11% at the moment.

The largest is Fidelity China Special Situations (LSE: FCSS), which merged with Abrdn China last year and has assets of £10.6 billion. This fund isn't exactly a value fund, but it does lean toward value and small- and mid-cap stocks in comparison to the others. Despite having the highest gearing (currently 23 percent) in a challenging market, it has produced the best return of the three over the most recent periods.

Then comes JPMorgan China Growth and Income (LSE: JCGI) at 225 million. This aims to pay out a quarterly dividend of 4 percent NAV annually, but the portfolio is skewed toward growth rather than income investing. The payout will therefore be partially funded by capital, as is becoming more and more typical with higher-yielding trusts.

With 160 million shares, Baillie Gifford China Growth (LSE: BGCG) is last and focuses on growth stocks in industries like technology. This is the old Witan Pacific trust that was given to Baillie Gifford in October 2020 with a new focus on a single nation. Given the crackdowns, this was not the best time to do it, and it has since declined significantly, albeit better than JCGI. But its strategy might work if the situation is actually improving.