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Everywhere we look, headlines point to China’s immense influence and economic growth. Since the country implemented free market reforms in 1979, it has grown at an exponential rate (9.5% average annual GDP growth up to 2018). With the rise of China’s power and middle class, many powerful Chinese companies have emerged with a global reach – Alibaba, Tencent, DiDi, Baidu and DouYu, to name a handful. Many Western investors have, of course, taken notice and want to profit from this growth. Yet is investing in China a good idea?
In this article, our financial planners at Cedar House explain some of the risks and rewards to consider when investing in China-based equities. We hope you find this content useful. If you’d like to discuss your own financial plan with us, please contact our team for more information or to access personalised financial advice:
020 8366 4400 or enquiries@cedarhfs.co.uk
The rewards
Bluntly, the potential returns on offer from many Chinese companies is simply staggering. The cost of Chinese stocks, moreover, is often very cheap when compared to their “fair value” (an estimation derived from analysing each company’s fundamentals). Many of them are now also listed on US-based exchanges, such as the NYSE, making it easier for retail investors to get involved. Take Alibaba as an example. Often dubbed the “Amazon of China”, this e-commerce business has grown hugely since it listed on the NYSE in 2014. Many investors are currently excited by its low stock price ($162.29) – despite its recent bear run – and believe it could rise significantly over the next few years.
The risks
Investing in China comes with unique risks that need to be weighed carefully. Firstly, there is political risk. US-China relations have been very tense since 2018 due to the Trade War (tariffs). Many Chinese stocks have already been kicked off US exchanges (e.g. China Telecom) and more could follow as regulators enforce the new Holding Foreign Companies Accountable Act, which requires foreign companies to be subject to US auditors.
Secondly, there is risk from the Chinese government – which has regularly shown willingness to interfere with Chinese stocks. In November 2020, for instance, authorities suspended the IPO (initial public offering) of Ant Group; a Chinese company owning the country’s largest digital payment platform, Alipay – leaving investors $3tn out of pocket. Thirdly, there are concerns about the lack of transparency over accounting practices in China. Reporting is not standardised as it is in the USA, and it is not always easy to find important information (e.g. insider trading). A case in point is the Luckin’ Coffee scandal, where over $310m in sales figures were fabricated.
Finally, it’s vital to note that China does not usually allow non-Chinese citizens to own shares in its publicly-traded companies. A-shares are open to foreign investors (i.e. companies on the Shanghai and Shenzhen Stock Exchanges). However, shares of many Chinese companies like Alibaba and Tencent can only be owned by foreign investors via a complex structure called a VIE (Variable Interest Entity). This is, essentially, a shell company listed in a country like the Cayman Islands which has a complicated web of contracts with its China-based company – giving it a claim on the profits and assets. Foreign investors do not, therefore, own underlying assets when they buy shares using a VIE – and China could ban the VIE in the future.
Implications for investors
Many people understandably perceive the rewards of investing in China to be worth the risks. Here, there are some good practices to follow to help protect your investment(s):
- Have a backup exchange. Some Chinese companies are listed on multiple exchanges. As such, if, say, the US bans a stock from its exchanges then your broker might be able to move your shares to another (e.g. The Stock Exchange of Hong Kong).
- Look for heavyweight endorsement. An investor should never invest in a stock purely because a well-known investor has. Yet many of these people can access information about Chinese companies’ numbers which retail investors cannot. This can give you more confidence in the financial statements.
- Keep China’s goals in mind. If you are worried about the Chinese government stepping on the company you are invested in, ask yourself whether the company aligns with the Communist Party’s overall aims for the nation. These focus heavily on building an edge in technology, growing the middle class and protecting national security. A company like Alibaba, for instance, arguably helps with the second. However, China recently banned for-profit tutoring, leading to companies such as TAL Education Group plummeting in stock price. Partly, this is because Chinese President Xi Jinping sees for-profit tutoring as an impediment to halting the country’s declining birth rate.
- Diversify. Do not put most of your portfolio into Chinese stocks – however attractive the returns may appear. Spread risk across multiple countries, regions and markets to lower your exposure in any one of them. A financial adviser can help you do this.
Conclusion
Interested in discussing your financial plan with an experienced financial adviser? Get in touch today to discuss your financial plan with a member of our team here at Cedar House via a free, no-commitment consultation:
020 8366 4400 or enquiries@cedarhfs.co.uk