Five risks to China shares and how to play them

In the first part of this series, we heard from Mary Manning, portfolio manager, Ellerston Capital, Stephen Kam, Investment Director, Asia ex-Japan equities, Schroders, Hong Kong, and Nicholas Yeo, director and head of equities - China, Aberdeen Standard Investments. Our three experts have already provided a compelling case for investing in China equities, but what about the risk? 

If you want high returns, you need to be willing to take on a certain amount of risk. But there are ways in which our experts are diffusing the risk, and in some cases, myth-busting away some of the risks commonly associated with investing in China.

Every asset class has its own challenges.

"China is not a homogenous market and the risk and challenges differ depending on which part of the China market you are investing in: H shares, A shares or ADRs," said Manning. 

Here's what they said: 

#1 Geopolitical risk: US-China relations 

Mary Manning believes that ADRs are at the highest risk from geopolitical tensions, particularly with the US. ADRs are Chinese stocks listed in the US, such as Alibaba, Baidu, Pinduoduo and many other technology stocks. 

"ADRs came under fire during the Trump Administration because Trump and the SEC threatened to de-list them if they did not comply with US auditing requirements," said Manning. 

While under a Biden administration, Manning believes the risk has abated it still remains a "credible risk". 

Yeo agrees this risk is here to stay: "US-China relations will remain an evolving feature of the geopolitical landscape for many years to come". 

Manning said there are ways companies are actively trying to mitigate this risk. Many companies, particularly large-caps, are choosing to have a dual-listing in Hong Kong.  

"Another way to mitigate the risk of ADR delisting is to own the Hong Kong Exchange, the natural beneficiary of repatriation listings," said Manning. 

Outside the ADR market, Nicholas Yeo argues the Chinese government is trying to reduce this risk factor through more domestic demand and production.

"China's increasing economic self-reliance dilutes the significance of who sits in the White House and so mitigates this risk to some extent," he said. 

#2 (Internal) political instability 

Manning myth-busts the investment risk of internal political stability between China and Hong Kong. 

"First, China does not want Hong Kong to lose its status as a global financial centre as it is critical to the success of China's financial liberation and yuan internationalisation strategies," said Manning.

H-shares, or stocks that trade on the Hang Seng, are at little risk to ongoing tensions, she argues. She believes this is a very liquid market, which is easy to hedge via simple options strategies. 

"For example, I have used Hang Seng puts in the past as a way to hedge China-related risk," said Manning. 

However, A-shares (stocks listed on mainland China), said Manning, are subject to a number of risks from Beijing political strategies. This includes potential nationalisation, ad hoc regulatory changes, share suspensions, CNY convertibility, to name a few. 

"There are very few ways to mitigate against these risks," said Manning, which is why she only allocates about 3% of her portfolio to this asset class. 

#3 Governance - the road to ESG 

China has been rapidly re-working its reputation in environmental, social and governance (ESG) realms. Governance in Chinese stocks is perhaps the most important of the three for performance, while the environmental factors have been driving a revitalisation of growth, particularly with regard to Beijing's carbon neutral targets. 

Nicholas Yeo believes it is necessary to choose companies to invest in on an ESG basis to improve the chance of backing a winner and avoid "loss-making corporate failures and scandals". 

"Having invested in China for the past 30 years and engaged consistently with management teams on the ground, we have observed incremental improvements in environmental, social and governance (ESG) standards," said Yeo. 

Stephen Kam, similarly, places a high agenda on ESG and the ability to "gain access and conduct thorough due diligence and research on companies".  

"Gaining comfort with the level of corporate governance, including the integrity of management and the quality of their execution, is key to investing in China, in our view," said Kam. 

Kam has a team of 17 research analysts on the ground who are focused on identifying attractive opportunities in the market and are able to conduct the necessary due diligence to avoid companies with a poor track record in governance. 

#4 Pandemic recovery 

Like most investors in today's market, our experts are heavily focused on the COVID-19 recovery efforts and vaccine roll-out. One of the risk factors that has started to shine through is that China might be leading the way on inflation. 

Stephen Kam believes China is in a similar situation to the rest of global markets in the steep recovery, despite a recent correction.  

"Equity valuations are clearly already pricing in a large part of the recovery in earnings expected in 2021 ... The prevailing optimism is not unreasonable given the scope for a sustained snapback in activity in the next two years," he said. 

Yeo believes that China is working to mitigate any risks which may hinder the future growth trajectory. 

"China is encouraging localised investment in technology and software services with enterprises becoming less reliant on foreign equipment. In addition to rising investment in automation, this is making China's technology market increasingly addressable for investors," said Yeo. 

#5 Market froth and retail investors 

One other thing which Kam mentions with regard to valuations is the excess levels of froth in markets, driven in part by the swarm of retail investors entering into trading. 

"We saw clear signs of froth in the very high retail investor activity in many markets. Signs were also evident in the strong recent performance of initial public offerings (IPOs) in Hong Kong, and the more general preference for conceptual 'story' stocks, many of which are still loss-making," he said. 

The most impacted sectors, all of which looked "very stretched prior to the recent correction", include:

• Biotech
• e-commerce
• software
• 5G equipment
• Electric-vehicle-related and certain popular China A-listed consumer stocks.

Despite a recent pull-back in pricing, Kam believes there are still many stocks trading at excessively high valuations. He believes a "selective approach" is necessary for the current market with a focus on bottom-up stocks.

Conclusion

Having a sound understanding of the risks will help navigate this market. The key takeaway here is to know that these stocks, even these exchanges, aren't singing from the same songsheet. You need to be careful where to invest. 

Hit the follow button for the final part in the series where we showcase our experts' stock picks for contrarian opportunities in China right now. You can also read Part One below. 

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