Is this out-of-form region an opportunity or a value trap?

Many investors have abandoned China and some have labelled it “un-investable” after its three-year bear market, a property crisis and disappointing growth.

However, let’s remind ourselves that China worries are not new. Every few years, we seem to go through a new wave of unease about developments in the region. For example, in 2015 and 2016, we saw Chinese economic weakness, financial panic and a strong policy response. In 2018, we faced trade wars with Donald Trump. In 2019, we had the Hong Kong protests. In 2020, we had the Covid outbreak in Wuhan, with years of lockdowns and economic instability. And now, we have a new wave of concern.

China currently has many of the hallmarks of a contrarian opportunity, including the following: terrible economic or corporate news, sustained selling, reductions in share prices, lows in price versus fundamentals, and alarm, disdain and pessimism from the investing community. However, on the flip side, a checklist for value traps should include technological obsolescence, potential government policy shifts, and excessive leverage at an industry or country level. The latter two are considered to be applicable to China by many.

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We must recognise that our behavioural instinct is to give too much importance to recent experiences, in this case disappointment, when thinking about what could happen. The evidence from our Morningstar flows’ data is that these biases lead investors to make bad-timing decisions that detract value.

Considering this, we have taken the opportunity to highlight a couple of active funds on the ii Super 60 list of investment ideas with significant exposure to China. By investing in these products, instead of an index, investors can potentially manage the idiosyncratic risks of underlying companies in China.

JPMorgan Emerging Markets

Relative to other emerging markets opportunities, an investor could defer the China asset allocation decision to an experienced fund manager.

Austin Forey is a savvy and disciplined investor who has managed the JPMorgan Emerging Markets Ord (LSE:JMG) strategy since 1994. The manager benefits from the research support of a 100-strong team of emerging markets and Asia-Pacific portfolio managers and analysts, which includes significant resource dedicated to China. The investment process follows JP Morgan’s quality and growth focus, which we rate highly. The manager seeks firms that boast quality franchises, consistent earnings streams and solid returns on equity.

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The trust had a 16.4% allocation to China as of end of January, down from 25.8% the previous year. It holds less than the MSCI Emerging Markets Index, which has a 24.5% allocation to China. A year ago, the index had 32.9% in China (with the weighting decline down to China’s underperformance).

Forey’s ability to move away from the index weights has benefited the trust recently as the Chinese stock market has lagged. However, the flexibility to revert is highly beneficial as fundamental views change.

At an -11.6% discount to net asset value (NAV), as of 26 April 2024, the trust provides an opportunity for investors to benefit from not only asset appreciation, but also the potential narrowing of the discount to NAV due to improved sentiment in this space.

Fidelity China Special Situations

Investors tend to bucket emerging markets as one, but as they are heterogeneous, often the real opportunities present themselves at a country, sector or regional level. Therefore, an investor could look for a pure play on Chinese equities through Fidelity China Special Situations (LSE:FCSS).

The trust has been managed by Dale Nicholls since April 2014, when he took over from veteran investor Anthony Bolton. Nicholls has been part of the Asian equities team at Fidelity since 1996. He has a proven ability in extracting value from a research team that is extensive, has a large footprint in China, and provides a high level of support in terms of ideas generation and fundamental research.

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For the core of the portfolio, the manager seeks undervalued companies that have the potential to deliver over the long term through good industry dynamics, competitive advantages, and good incremental returns on capital. Strong management teams are essential, and Nicholls conducts a large number of meetings with company management every year to make his assessments.

Versus the MSCI China index, there is a clear bias to small- and mid-cap companies where the manager believes opportunities exist due to a lack of coverage. At the sector level, there is often an overweight to industrials and information technology. Unlisted companies are permitted up to a maximum of 15%, which is generally used, while the board believes gearing should be deployed as a structural component and this is typically around 20%.

The trust is viewed as a high-quality option in the China equity space. However, investors should be aware of the heightened risks posed by small-caps, unlisted companies, and structural gearing.

At a -9.5% discount to NAV, this trust also provides an opportunity for investors to benefit from not only asset appreciation, but also the potential narrowing of the discount to NAV due to improved sentiment towards Chinese equities.

Jack Paterson, is an associate investment analyst, manager selection services, at Morningstar.