Three pros on why China’s political risk is a price worth paying

Fund managers explain why China’s stock market underperformance in 2021 should not dissuade investors. 

President Xi Jinping of China

Having performed strongly following the onset of the Covid-19 pandemic, it has been a reversal in fortunes for China’s stock market in 2021.

Year-to-date the MSCI China Index has fallen 20.7% in sterling terms, according to figures from FE Analytics. Up until July returns were flat, but what followed next was unexpected political meddling. The Chinese government launched a crackdown on its own technology and education industries, sparking a sharp sell-off for the entire market.

In short, a number of new regulations have been imposed, which threaten the future earnings and profitability of companies in those sectors, while political risk and uncertainty have led to concerns over whether capital from overseas investors would be withdrawn from China’s equity market. 

In addition investor sentiment has been knocked by fears about a slowdown in economic growth in China, particularly following the giant property developer Evergrande (SEHK:3333) teetering  on the brink of collapse. The Chinese firm's liabilities exceed $300 billion. 

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Professional investors with sizeable exposure to China argue that political risk is nothing new, and that it is a price worth paying. There’s an element, of course, of such fund managers talking up their own books, but nonetheless each makes a compelling case in regard to why China’s recent stock market underperformance should not dissuade investors. 

Moreover, as the world’s second-largest economy and home to some of the world’s most-exciting entrepreneurial businesses, China is difficult for investors to neglect in their portfolio, despite its political risks.

Hugh Young, the veteran Asia equity investor and fund manager of Aberdeen Standard Asia Focus (LSE:AAS) investment trust, argues that “in many senses it has made China less risky because we have now seen the risk occur”.

He adds: “How China has developed is to be gung-ho for development and leaving regulation to lag behind. So what we saw this year was regulation coming in. Regulation, to my mind, that is quite necessary and healthy.”

According to Young, who was recently interviewed on our Funds Fan podcast, the new regulations have changed the nature of some of the companies in the education and tech sectors. In particular, he notes that some of the education firms have seen their business models damaged.

Young, however, has been viewing the falls for some of the big tech giants as a buying opportunity, including Tencent (SEHK:700).

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“We have seen the risks come to fruition, which as a result means the market is now less risky. It has caused us to be a little more optimistic on some of the internet companies, where we have seen the share prices fall,” says Young.

Young adds that Chinese tech companies will no longer be “the go-go growth stocks of old”, but are well-placed to continue growing their market share. He thinks the bulk of the political crackdowns have already occurred, and that it is not in the interest of China’s government to kill off enterprise and innovation.

He adds: “I would argue that in many ways China has been the most innovative and enterprising of countries as far as technology is concerned. The amazing transformation we have seen over the past 10 years in innovation, and in fact China is leading in some of these technologies, and I think that will continue.

“But will we get the super profits we have had in the past? No, I don’t think we will. And, again, that’s reflected in the valuations, which is why we have been a lot more comfortable adding to shares at these prices.”   

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Other investors who back China, including Austin Forey and Dale Nicholls, also argue that China’s equity market is no riskier than it was prior to the unexpected political interventions.

Forey, fund manager of the JPMorgan Emerging Markets (LSE:JMG) investment trust,points out that regulatory risk has always been part and parcel of investing in China. As a result, he is continuing to back the region, despite the recent government interventions. The trust has a third of its assets in the region, with Tencent its second-biggest holding.

Speaking to interactive investor, Forey said: “My overall take is that investors have been reminded recently that China has always had these risks. If you look at it, it has a corporate sector that is relatively new. There are some places in the world where you find companies that can trace their roots back 100 years or more. Obviously, that is not the case in China. And so you have a lot of fairly young companies.”

Forey adds that China’s regulatory system is trying to evolve and keep pace with the rapidly changing world, including technological advances. On top of that, he adds, China’s political system is very different to what we have here in the West.

He continues: “So when you put all those things together, I think you should basically always have thought that China had some particular risks which you needed to assess. And this has been really a reminder of that, in my opinion, rather than a radical change to what we’ve actually been coping with for the last 20 years as a whole.”

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Nicholls, fund manager of Fidelity China Special Situations (LSE:FCSS) investment trust, notes that following the significant recent correction in technology-related names, he feels “the risk/reward pay-off is now tipping much more in our favour in these companies”.

He adds: “While there is still risk of new regulation, as we think about what could come next, there is a good chance that we are near or close to a 'peak' in terms of news flow. The government has ambitious long-term goals in areas of economic development and innovation.

“Clearly these will be difficult to achieve without a vibrant private sector. At the same time, valuations for many companies have moved to historical lows and look even more compelling when we compare to global peers.

“As is often the case with broad-based corrections, some stocks with lesser regulatory risk have also been sold off, presenting opportunities.”