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Summary

  • Shares of Chinese companies trade for nearly half the price multiple of stocks in the S&P 500 but pay a dividend yield 1% higher.
  • The government has stepped in over the last two years with stimulus programs that have supported asset prices and driven indexes higher to the end of the year.
  • China-focused funds have lost up to 14% so far this year on weak economic data but could rebound if the government repeats the pattern of the last two years.

The annual chorus of weak Chinese economic data has spooked the markets, weighing slightly on U.S. shares but driving domestic stocks down double digits. The pattern is a familiar one for investors and if the last couple of years are any clue, now could be a very good time to start building a position. Whether the government comes in with another stimulus to boost asset prices or allows for slightly lower growth, shares are attractively priced and provide the possibility for strong long-term returns.

Anatomy of a pattern

Pundits have been calling for a hard-landing of the Chinese economy for years but the government has always been able to manage growth. Over the last couple of years, forecasts have been at their most dire in the spring after data has disappointed. Whether lower economic data in the first few months of the year is a function of the Lunar New Year or a true sign of a sluggish economy, the government has shown a predictable pattern of support.

Weak export and factory data in early 2012 was followed in July by the announcement of $70 billion in railway infrastructure spending. This stimulus was followed in August by the announcement that local governments would be carrying out $1.3 trillion of stimulus projects over the next three to five years.

Second quarter GDP growth that just barely met the government's annual target of 7.5% in 2013, combined with a government Purchasing Managers' Index at an 11-month low, was followed in July by stimulus. The government announced the elimination of value-added and operating taxes on businesses with monthly sales of less than $3,250, to be implemented in August of that year. The government also promised to simplify the approval procedures and reduced administrative costs for exporters.

Consequent to the stimulus measures each year, the markets rallied into the end of the year.

(click to enlarge)China Market Returns 2012 and 2013

Building a position through the summer

Now the markets are falling again on weak economic data with the iShares China Large-Cap (NYSEARCA:FXI) down 14% and the SPDR S&P China fund (NYSEARCA:GXC) down 10% year-to-date. Industrial output increased just 8.6% over the first two months of the year, compared to the year prior, and early data has been weak across the board in retail sales, investment and exports.

The Chinese government announced last week that it would spend more than $162 billion in redeveloping more than 4.75 million homes this year. Rules for residence-registration and bond issuance by local governments will also be relaxed as the government tries to fine-tune its urbanization program. The program is relatively small compared to other stimulus so it may be followed by more spending later on this summer.

It may take some time for spending to flow through to economic data and I'm expecting monetary easing this year as well. The producer price index has been negative for two years and fell 2% in February from the prior year, so inflation should not be a concern. The central bank has not cut the reserve requirement for banks since May of 2012 and could come back in to support the market.

For market exposure, I prefer the iShares China Large-Cap fund for valuation and size. The fund holds 25 of the market's largest companies with an overweight in financials (54.0%), telecommunications (13.5%), energy (12.4%) and information technology (12.2%). The price-to-earnings multiple on the fund is misleading because the largest holding, Tencent Holdings (OTCPK:TCEHY), is 12.2% of assets and has a price of 58.6 times trailing earnings. Excluding the shares in Tencent, the average price-to-earnings ratio of companies in the fund drops to 9.4 times trailing earnings. At a price multiple nearly half that of stocks in the S&P 500 (17.7 times trailing), the fund pays an attractive 2.8% dividend yield.

The iShares China fund invests in the some of the largest domestic companies in the market, many with implicit backing by the government. While government control may limit growth to an extent, it is also highly unlikely that any of these firms will be allowed to get into any real trouble.

The long-term economic story for China is undeniable with a goal of 7.5% growth on an $8.8 trillion economy. Even if growth slows sequentially over the next few years, the absolute growth in the economy will drive global growth and support asset prices.

Some investors prefer the smaller SPDR S&P China fund for its greater sector diversification across the market. The fund holds shares of 250 companies with large weights in financials (31.5%), information technology (18.8%), consumer goods (13.0%), energy (10.8%) and industrials (8.6%). Tencent Holdings is also the top holding of the fund at 6.8% of total assets. The companies in the fund trade for an average price of 9.0 times earnings and pay a 2.5% dividend yield.

I prefer the larger fund for the ability to fine-tune my investment with long-term options. I do not mind the over-weight in financials, which is just over 20% higher in the larger fund, since the group should do well on market liberalization over the coming few years.

There is no way of telling when Chinese shares will rebound off of stimulus measures but valuations are extremely attractive already and I intend to build a position through the summer. Either of the large market funds provide a cash yield above that of the S&P 500 at half the price multiple. Slowing or no, the Chinese economy is set to grow by more than $650 billion this year and will support asset prices.

Source: Buy China On This Multi-Year Pattern