The Contrarian Case for China: Deep Value, High Dividends, and the Potential for Fiscal Stimulus
Why China’s Stock Market Deserves a Second Look
Chinese stocks are arguably the most disfavored investment in the world right now. The Shanghai Composite—the largest stock exchange— is down 14% over the last 12 months and is now worth 57% less than it was 17 years ago since reaching its all-time high.
When sentiment is universally negative, a contrarian perspective deserves consideration. The root causes of this decline stem from a combination of domestic and international factors. Domestically the Chinese administration deployed policies that effectively impaired private initiative in general and more specifically cracked down on technology companies, a key engine of equity markets. The controlled 'demolition' of the property bubble (pun intended) and the mismanagement of the pandemic further depressed stock prices. Internationally, escalating tensions between the U.S. and China have prompted widespread divestment by global investors. GDP data indicates an economy heavily reliant on export-led industrial activity—a precarious growth driver given the excess capacity in many sectors and the rise of trade barriers. Conversely, price declines in key consumer sectors and falling retail sales suggest the danger of a deflationary spiral. This presents a major concern to policymakers, as a growing crisis of confidence could evolve into a structural issue.
Thus far, Chinese leadership has eschewed major fiscal stimulus aimed directly at boosting demand, opting instead for traditional monetary stimulus deployed through the banking system. Results have been modest and a policy shift may be ahead. Chinese leaders have keen sense of history and understand well that the right to rule—what in Chinese culture is referred to as the "Mandate of Heaven" (天命) — is retained only as long as the ruler serves the people's interests.
The development of a prolonged period of economic stagnation and deflation along the lines of what experienced by Japan since the early 1990s is not a politically appealing option for China. The majority of its population has yet to attain full middle-class status, and youth unemployment has reached elevated levels. The Chinese people may not take kindly to "shared stagnation" in lieu of the promised "shared prosperity." The cautionary tale of the former Soviet Union, not to mention 3,000 years of dynastic history, undoubtedly weighs on the minds of Chinese policymakers. A critical mass of economic, political, and cultural indicators suggests that China may embark on substantial fiscal expansion at some point in the future. If so, could this present an opportunity for contrarian global investors?
Setting aside domestic sentiment, fundamentals for Chinese public companies are not structurally dire. The property bubble will eventually be reabsorbed, and exports are being reoriented towards emerging economies. These markets will continue to grow, along with demand for Chinese goods and services, even in the face of increasing trade frictions with the U.S. and other major developed economies. The overarching global macroeconomic environment is not unfavorable either. The largest economies are likely to maintain accommodative fiscal conditions, while on the monetary side, ample liquidity must be preserved to avert any credit events.
Valuations certainly support the notion of a potential opportunity. Chinese stocks have become the epitome of "deep value," trading at long-term price-to-earnings ratios just above 11 —by far the cheapest among major global stock markets.
The cash-to-market-cap ratio, which reflects the relationship between cash generation and market valuation, provides an even more striking measure of how attractively these companies are priced. For the top 10 largest non-financial Chinese companies, cash and short-term securities account for over 20% of their total market cap. In comparison, the same ratio for the top 10 largest U.S. companies, even with Berkshire Hathaway's massive cash reserves, is just 3.6%.
Given the risk involved in this thesis, a prudent approach for a contrarian play would be to focus on large-cap stocks with high dividend yields currently exceeding 7%. Dividends have become a key priority for Chinese authorities, who issued new regulations in April aimed at increasing payouts and returning more cash to shareholders. As a result, on a total return basis, the high-dividend index has rallied and it is now up more than 12% for the year, compared to the MSCI China Index, which remains essentially flat.
If policymakers acquiesce and enact fiscal support, a 50% upside to current valuations is feasible, and even then, Chinese stocks would remain below their historical CAPE average of 18. Should fiscal stimulus remain elusive, high-dividend stocks would at least ensure some return for investors. Additionally, an extra source of returns could come from the appreciation of the Chinese currency, which would benefit USD investors. Although this outcome is currently out of consensus, a growing number of geopolitical factors indicate that this may actually become the more likely scenario moving forward.
Contrarian bets, when successful, are by definition the most rewarding, as 'alpha' returns can only be generated outside of consensus and by making decisions that the majority does not anticipate. Yet there's no question that this trade is fraught with risk; geopolitical discord may sow even more challenges for China's export, and policymakers may uphold that fiscal stimulus is just not ideologically appropriate for the country. The potential rebound in Chinese stocks, if it materializes, should therefore be approached with careful selection of investment vehicles, prudent position sizing, and stringent risk management. As always, investors are best served by making decisions based on their unique risk profile and time horizon.
Disclosure: Not investment advice. Do your own research. Hold all assets mentioned. X @pietroventani for more timely comments and updates.