China Stocks Fall, But Investors Should Stand Up And Take Note

Includes: CHIQ, FXI, HAO
by: Emerging Money

By Joseph Hogue, CFA

Investors in Chinese stocks cannot get a break as the mainland index fell to its lowest level in four years, and normally defensive consumer-staple companies fell the most in three years.

While exporters welcomed the news that the official Purchasing Managers' Index rose to 50.6, signaling growth in the manufacturing sector, consumers are not quite as confident in the recovery. The mainland Shanghai Composite index has fallen 11% this year and will finish the year in the red again for the third consecutive year. The non-manufacturing index also increased last month to 55.6, its highest reading in three months.

For the Chinese, economic growth of 7.4% may be a hard reality compared to the double-digit gains over the last decade. Despite the slowdown, retail sales continue to grow by 14.5% a year and non-farm fixed asset investment has remained strong. Though the better economic data is causing some analysts to reevaluate their calls for more stimulus, consumer inflation of just 1.7% should leave the government plenty of room to ease if it feels the need.

It has been a tough year for investors in the space, but it looks as if the light is beginning to appear at the end of the tunnel. I believe that strengthening data, along with great fiscal and economic fundamentals relative to most other large economies, means investors can risk being a little early to the party and start accumulating shares now. It may take another couple of quarters for sentiment to fully turn, but asset prices should increase next year.

The FTSE China 25 Fund (NYSEARCA:FXI) is the largest ETF in the space, with about 16.1 million shares traded daily. The fund trades for 13.0 times trailing earnings and pays a 2.5% dividend yield. A common criticism of the fund is its allocation to financials, 58.1% of total holdings, followed by a relatively small allocation to telecommunications (16.3%), energy (14.9%), and basic materials (8.7%). This is why I would suggest a dual investment in another fund to diversify across sectors.

The Guggenheim China Small Cap (NYSEARCA:HAO) may not be as heavily traded as the larger fund, with around 158,000 shares traded daily, but this is not usually a problem for exchange-traded funds because they can buy or sell underlying shares to create or redeem units. The fund holds shares in 226 companies with market cap between $150 million and $1.75 billion. The shares provide a good diversification by sector and market cap relative to the larger fund with 24.5% in industrials, followed by financials (18.7%), consumer discretionary (14.5%), materials (13.1%), and consumer staples (9.6%). The fund trades for a relatively cheap 7.9 times trailing earnings and pays a 2.9% yield.

Smaller still is the Global X China Consumer ETF (NYSEARCA:CHIQ) with just over 100,000 shares traded daily. The fund holds the shares of 40 companies in the consumer sector and is fairly well-diversified across industries with retail (22.2%), food (19.2%), consumer services (14.6%), automobile (12.9%), health care (10.6%), and household goods (9.6%). The fund trades for a relatively expensive 17.7 times trailing earnings and only pays a 0.4% dividend yield. I like the fund for its focus on the Chinese consumer, but would probably only recommend it to the long-term consumer because of its relatively expensive current price. Short-term investors may want to wait for the possibility of a better entry point over the next couple of months.