Buying the Dip – China Edition

As I mentioned in my last post; one of the most difficult domestic trends to manage in 2014 has been the “herding instinct” of many investors. While sector and style box rotation has helped make this year at least more interesting if less profitable than last year, the pullback last week demonstrated that when push comes to shove, investors of all stripes and creeds will be selling EVERYTHING and not just the biggest losers. So for those with an itch to invest and money to put on the table, where can you go where you’ll be well treated? Well a funny thing happened on the way to the exit sign last week; some investors went back to the most unloved of international markets, China. And they’ve been going there for months.

Yes China, the People’s Republic thereof, not Taiwan also known as the Republic of China which has trounced the returns of its large mainland cousin. China, the saber-rattling land of environmental disasters, newly constructed and totally empty cities, funky statistics only an Argentinian could love with a banking sector on the verge of collapse and where the new leaders are actively trying to imprison and execute their immediate predecessors. That China.  Don’t believe me?  Look for yourself.

spxAll of this negativity has helped drive equity returns almost nowhere over the last three years and now offers perhaps the most “undervalued” global market besides Russia. And both are not without their risks. Over the last five years ending yesterday, the S&P 500 has advanced over 92.8% while the Shanghai Stock Exchange has lost nearly 36% of its value while one of the older ETF’s offering exposure to Chinese stocks via Hong Kong, the iShares FTSE/Xinhua China 25 Index (FXI) is up over 7.3%. So far, unexciting and only the performance a global macro fund would love to charge you 2 and 20 for.

But the worm has seemingly turned so far in 2014. After spending much of the year in the red, things became desperate in March when most major Chinese bank stocks feel to the point where their price-to-book ratio was below one as investor discounted the value of the existing loan book because of the on-going financial woes. Since then, the Shanghai composite double based and then exploded higher in July and dragging the Hong Kong oriented China ETF’s with it. My preferred vehicle, the iShares MSCI China Index (MCHI), has had a great few months rising over 16% in the last 3 months to bring its YTD return to 6.23% and during the S&P 500’s stupendously awful last week, it even managed to turn a small profit. I’m sure my more technically oriented friends are now just waiting for a pullback as I’m sure today’s poorly received HSBC China Services PMI is to provide us, but the real question is what could propel us higher from here.
The real China story isn’t that the situation has gotten dramatically better, its more about that it hasn’t gotten dramatically worse so you need to step back from the quantitative and go to the qualitative.

1. Despite concerns over financial stability – the anticipated implosion in a fiery haze of various Chinese investment trusts has not yet occurred.
2. Financial Easing – the PBOC has recently announced cuts in the reserve requirement for a handful of the largest banking institutions. While not quite a formal easing operation, it does show a willingness to consider other alternatives and a flexibility that had been previously sorely lacking.
3. Financial Openness – Trying to stem capital outflows, China has shown a desire to expand investor access to the domestic A-share market and it’s lighting up the board for Chinese investment firms and brokerages.
4. Political Consolidation – The new leadership has been living it up with an old-school purge of the prior leadership, trying to root out corruption wherever it can. While not quite democracy in action, it shows a commitment to change as well as improving economic efficiency as well as discarding the previous regime’s policies and hopefully stabilizing the economy.

Make no mistake, China is still a country caught in the midst of a slow motion disaster and you can read more about that on Michael Pettis’ excellent blog here, but the country does meet the Yinzer Analyst’s favorite criteria for determining to deploy capital….THEY’RE EASING. We can argue monetary policy till we’re blue in the face but my viewpoint on 2014 has remain unchanged; monetary policy is tightening (less easy is more tight in my book) in the U.S., unnecessarily tight in Europe but could ease soon, and hopefully easing in Asia. Given the poor prior performance in China over the last few years. Now could be the time to take the plunge but consider what you’re buying first and the price you’ll pay.

Investing in China is still an experience in finding close substitutes rather than buying direct. Despite the increased willingness of China to cross-list Shanghai Exchange names in Hong Kong or allow more A-share sales to foreign investors, most Chinese oriented ETF’s and mutual funds invest in Hong Kong listed shares as MSCI has declined to add A-shares to their indicies. One of the largest and broadest products in that space is MCHI, but make sure to visit the iShares website here to find out more about what you’re buying. China’s financial problems are by no means resolved and like all emerging markets, bank stocks make up a large percent of the market cap. For MCHI, it’s over 35% and largely concentrated in the largest banking operations that have already seen a big share surge in 2014 with price-to-book rations trading closer to their western counterparts.

Diversification is also an issue; despite having over 140 holdings, 10 of those make up 51% of the portfolio with over 10% in Tencent Holdings. Tencent Holdings, up over 30% in 2014 has contributed slightly more than half of the returns of MCHI this year. That doesn’t mean you should give up on MCHI, but know what you’re buying first.

For those more adventuresome, five new ETF’s have recently been released offering direct exposure to the A-Share market, the biggest of which is the DB X-trackers Harvest CSI 300 China A-Shares (ASHR). With nearly 300 positions, the concentration risk is definitely lower with only 21% in the top ten names and with a correlation of nearly 1 to the Shanghai exchange, you’re definitely getting the systematic exposure to the Shanghai market. But what you’re also getting is a very different group of companies than MCHI, much smaller and less established with the average market cap being $10 billion versus $40 billion on MCHI. Holders of ASHR will have more stock brokerages and real estate companies than banks like MCHI along with higher fees, lower volume and a higher bid/ask spread.

In the near-term, both MCHI and ASHR have risen to what would technicians would consider overbought status and both are likely going to need a time-out before being allowed a move higher.

After a valiant struggle, MCHI seems to have finally moved above a long-term ascending wedge pattern and gotten back to its old high established close to the ETF’s inception date. What to watch for now would be whether it can maintain this level over the next few weeks while allow the technical picture to ease into a more neutral setting for a further advance higher.


Due to its short history, technical are of fairly limited use but the recent parabolic rise reminds one of a bump and run formation showing enthusiasm that may or may not be warranted. Watch out for profit taking off such a strong move!


Long-Term Investors – Shanghai Exchange
For those investors and asset allocators with a more long-term outlook, now might be the time to consider putting some capital to work as long as they temper expectations with the understanding that 7.5% GDP growth to infinity won’t be happening again. China has a host of issues to work through but it is possible investors have been too pessimistic for too long.



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