The question isn’t whether to invest, but how best to profit
More than a few Canadian investors are feeling gun- shy about Chinese stocks these days, and who can blame them?
Over the past three years, a handful of Chinese companies listed on equity markets in Canada have been caught up in share- eroding scandals, none bigger than Sino- Forest Corp., the TSX- listed timber seller that collapsed following fraud allegations in 2011 to become one of the country’s biggestever corporate debacles.
But while many people think Chinese companies are a risk not worth taking in the wake of these events, others believe just the opposite and despite persistent concerns about the integrity of China’s capital markets, they see plenty of opportunity to profit from exposure to the world’s fastest growing major economy.
“Recent economic data indicate that China is on track to grow at 7.5% this year and we are seeing a gradual rebalancing of the economy towards more contribution from the domestic consumer,” says Christine Tan, portfolio manager at Excel Funds Management Inc.
“We believe most Chinese stocks are trading at a discount to their earnings growth potential and expect 10- 15% upside over the next 12 months. We also have a favourable view of the renminbi.”
For Ms. Tan and others who invest in China, the bigger question is not whether to invest, but how best to profit from it in a way that mitigates potential risks.
Her primary focus is to perform an extensive due diligence audit on each company she invests in by visiting the assets or businesses on the ground in China.
She also pays close attention to the cash flow statement of each company in her portfolio to better assess their true financial situation.
“While there can be some subjective flexibility in revenue or expense recognition, cash flow is cash flow,” she said.
Investors should understand how management is being compensated as well, she said. Her preference is for compensation plans that reward management for risk management and return on equity ( ROE) or return on invested capital metrics, which speaks to financial discipline.
“We also favour simple businesses with an operational track record and an experienced management team,” she said.
“Last but not least is ensuring the company implements good corporate governance like separating the chairman and CEO role so the former acts as a check on the CEO. Investors should also ensure that there are independent and experienced directors on the board.”
Investors may purchase Chinese stocks on the Shanghai and Shenzhen stock exchanges, but also on several other venues around the world.
A select number of professional foreign investors are eligible to buy yuan- denominated A- shares, which trade alongside B- shares on the mainland exchanges.
The A- share market, which is generally for Chinese citizens, is only open to institutional investors outside the country who have been approved under the Qualified Foreign Institutional Investor ( QFII) program.
The China Securities Regulatory Committee has been gradually increasing the QFII program over the last few years, most recently from $ 80- billion to $ 150- billion in July, as one of several measures to gradually open the domestic stock market to foreign investors.
B- shares, meanwhile, were created as a means for Chi-nese-listed companies to raise money from foreign investors who can’t buy A- shares.
They tend to trade at a lower multiple than A- shares but the trading liquidity is suspect, resulting in big share price moves.
Given these negative factors, professional money managers often purchase shares in Chinese companies that are publicly listed in Hong Kong — known as H- shares — and other exchanges around the world, including New York and Toronto.
Not surprisingly, Ms. Tan believes the best way to gain exposure to Chinese stocks is through mutual funds that have the flexibility to own stocks listed on all the different exchanges.
In Canada, investors have several mutual funds to choose from including the Excel China Fund and the Fidelity Asia Star Fund, as well as exchange- traded funds that provide exposure to China, including the iShares China Index fund and the BMO China Equity Index ETF.
Another option for investors is to forego Chinese stocks and invest in international multinationals that have exposure to China’s economic growth.