The Chinese Value Trap

From Growth To Value...

Investors involved in Chinese equities have transitioned their focus from pursuing growth prospects to seeking undervalued opportunities. According to portfolio managers, those who remain interested in exposure to the Chinese market are progressively embracing value investing. This investment approach centers on identifying stocks trading below their intrinsic value, as determined by various metrics, instead of prioritizing enterprises with substantial growth potential.

This change in strategy from prioritizing growth to emphasizing value corresponds to the substantial transformation in China's economic trajectory.
After a period of rapid expansion, the nation's economy is now facing challenges. Exports and manufacturing have weakened over the current year, the housing sector is experiencing a decline, and consumer prices are moving towards deflation.
A case in point is Alibaba Group, a major player in the Chinese internet sector. Although the company was a prominent success story during China's prolonged economic boom, its U.S.-listed shares have undergone a nearly two-thirds reduction in value since late 2020.

This drop was precipitated by Beijing's protracted regulatory crackdown on internet firms. Currently, Alibaba's shares are trading at approximately 10 times projected earnings, as per FactSet data, in comparison to Walmart's shares, which are trading at around 23 times projected earnings.

Does Red Capitalism Work?

Fraser Howie, co-author of "Red Capitalism," advises adopting a cautious stance. He contends that while recent years have led many to recognize the risks inherent in investing in China, there remains an excessive optimism with a prevalence of wishful thinking. A critical misconception, as per Howie, is the notion that the Chinese government wields all-encompassing power and outperforms Western counterparts in managing the economy.

The aftermath of the global financial crisis of 2008-2009 witnessed a resurgence of belief in China's economic prowess as it rebounded quickly and garnered substantial foreign investment.
However, the underlying reason for China's resilience—an extensive government-driven lending and expenditure spree—has become increasingly untenable, jeopardizing economic stability and the potential for a more severe future crash.

A Value Trap

While some contrarian investors may view the recent surge in pessimism about China as a tactical opportunity to purchase Chinese stocks in the short term, structural concerns persist for the medium term.

Declining profitability alongside increasing leverage signal possible overinvestment and misallocation of capital in select sectors.
Investors inclined toward Chinese value stocks must be vigilant about the potential pitfall known as the "value trap," referring to stocks that appear excessively undervalued but remain in that state even after acquisition.

Moreover, the factors that propelled China's growth over the past decade, such as an undervalued renminbi and robust population and investment growth, have weakened. The perception of unstoppable rapid growth has been dispelled, ushering in a more uncertain narrative for investors.

Disclaimer

Please note that Benchmark does not produce investment advice in any form. Our articles are not research reports and are not intended to serve as the basis for any investment decision. All investments involve risk and the past performance of a security or financial product does not guarantee future returns. Investors have to conduct their own research before conducting any transaction. There is always the risk of losing parts or all of your money when you invest in securities or other financial products.

Credits

Photo by Road Trip with Raj / Unsplash.