Is China Worth Investing In?

China has found itself in the news recently and the news is not good. China's government, the Chinese Communist Party (CCP), took drastic measures to reign in big tech. And the Chinese property market is wobbling due to fears of Evergrande's insolvency. So, many investors are beginning to wonder – Is China worth investing in?

However, this follows years of hype. The CCP continues to develop the country's economy, which is already the second-largest in the world behind the U.S.

Should investors steer clear or are recent fears the buying opportunity of a decade? The truth, as is often the case, lies somewhere in the middle.

Why China Is Important

Before we dive into the larger questions of this article we should probably first clear up what the big deal is about China.

Most retail investors have little to no direct Chinese exposure. Most people tend to focus on the American market. If they dare venture abroad, it is usually in similarly well known, stable jurisdictions such as Canada, the UK or the Eurozone. For many, China sounds as exotic as Russia!

But investors may be making a mistake to completely ignore China. After all, this country is the second largest economy in the world. And despite this, GDP per capita is still only 67% of America's. This means China still has a lot more room to grow and will likely eclipse that of the U.S. in terms of total GDP in the next few decades.

Plus whether we like it or not, the U.S. and Chinese economies are tied at the hip. And a significant change with one partner leads to big ripple effects in the other. Besides that, Chinese manufacturing is deeply interconnected with the entire OECD world in terms of goods it produces and the raw materials it consumes in order to produce them.

Basically when China sneezes, the world catches a cold.

Finally, China's highly ambitious One Belt, One Road infrastructure initiative could remake global supply chains in a Chinese image. And this would further cement the nation as the beating heart of the global economy as well as asserting China as a new large geopolitical player.

The Risks of Investing in China

Though the above makes Chinese companies sound like good long-term investment, it isn't so simple. First, let's look at the general performance of the Shanghai Index (SSE, its equivalent of the S&P 500):

China's index returned only 17% over five years. (That's not per year but over five years.) And that's despite China's being among the fastest growing large economies in the world and making up a significant part of global GDP.

In contrast, take a look at the S&P 500, which is regarded as the benchmark:

Over the same five-year period of time, the American index had nearly five times the SSE's return. How could that be?

Remember that the stock market isn't the economy. The economic drivers may be similar, but they may also be mutually exclusive. The way the Chinese stock market is set up accounts for the big difference between economic growth and stock market growth.

Problem 1: A-shares vs. B-shares

China's stock market is insular. Foreigners cannot freely trade in and out of listed stocks. Instead, the Chinese created a system with parallel “A” and “B” class shares for all Chinese stocks. The A-shares are open to locals and are traded in Chinese yuan. Foreigners trade the B-shares, which are priced in U.S. dollars.

Some exceptions exist but mainly only to very large financial institutions. Local retail investors dominate the A-shares market. And they focus on much shorter time frames in their investments than do foreigners. This led to a series of booms and busts in the country's local stock market over the years. According to Financial Times, retail investors accounted for more than 80% of stock turnover in the Chinese markets.

So though it is true that China has seen incredible growth in its economy, we must look at where the majority of this growth is coming from.

Problem 2: Evergrande and the Chinese Property Market

Contagion fears in the stock market came about in autumn 2021. This stemmed from the Chinese property developer Evergrande's possible collapse.

But how could a Chinese property developer have such a huge impact? Chinese real estate has an outsized impact on its GDP growth. For example, in 2019, real estate investment accounted for over 13% of Chinese GDP (PDF).

Evergrande is one of the country's largest developers. On top of that it owes a mind-boggling $310 billion of debt. This is mainly owed to state-owned banks, but the domino effect could have a dramatic effect on the Chinese financial system and its real estate sector, both of which are key drivers of the Chinese economy. As mentioned above, any slowdown in the Chinese economy can have drastic ripple effects across our hyper-globalized world.

Problem 3: The Chinese Tech Shakedown

Big tech is undoubtedly a big issue in the U.S., as people and governments come to the grips with the immense influence a small group of tech companies have over our society. China isn't free from these big questions either. But the country's unique one-party government responds with much more force than Westerners are used to.

We got a glimpse of that when the CCP stopped the initial public offering (IPO) of the fintech startup Ant Financial. It would have been the largest IPO in history. But controlling shareholder Jack Ma criticized the way the CCP handles entrepreneurship in the country. So Chinese premier Xi Jinping blocked the IPO.

If this stifling of standard capitalistic procedure wasn't enough to spook international investors, the CCP's recent “common prosperity” wealth redistribution plan may be what sets the economy over the edge.

Problem 4: Wealth Redistribution Plan

Recently, the CCP put wealthy business leaders on notice and strongly suggested that they begin donating their large profits to charitable causes in order to help the poor. Tencent, the largest internet company in the country, stated that it would give away $15.5 billion to social aid programs. Alibaba, Pinduoduo, Xiaomi and Meituan each came out with similar large pledges.

Problem 5: Shareholder Rights

This all feeds into one of the main fears most institutions and by extension regular investors have regarding China: Shareholder rights are nonexistent. And many people worry that Chinese companies won't reach their full potential since the CCP can overrule most anything.

Most large Chinese companies that are listed outside of China use an opaque VIE structure (usually based in the Cayman Islands). Investors in this type of structure have no shareholder votes and no guarantee that their units are really worth anything at all. Further complicating this situation is that the VIE structure is a legal gray area for Chinese security law. Companies want foreign investors' capital but the CCP bars any foreign ownership in Chinese companies.

The Rewards of Investing in China

We painted a bleak picture in the last sections. And we believe that any interested investor should carefully assess the risks of an investment before looking toward the upside potential.

But there may yet be plenty of upside in Chinese stocks. Though the Chinese capital markets with all of its quirks are not yet as stable as their American and European counterparts, a few Chinese companies have risen to compete globally on the market. Companies such as Xiaomi and Huawei have dug in deeply into the highly competitive smartphone market as well as other tech hardware niches. They present themselves as serious contenders next to rivals such as Samsung.

Software companies have long been regarded as Silicon Valley's golden goose. And they're a big reason for the continued outperformance of American indices compared to the rest of the world. But now they have competition from international Chinese software giants such as Tencent. In some ways China has even been ahead of the curve with its people's use of “super apps” like WeChat.

China already has world-class companies. Yet Chinese stocks are still hugely underrepresented in most institutional portfolios. Chinese companies make up 9% of global market capitalization. But they comprise only a puny 2.7% of international fund allocations. This represents lucrative upside. If Chinese markets continue to mature and investors buy the stocks, the surge of buying and money pouring in could send Chinese stock valuations soaring.

Opportunities Abound

The lack of institutional coverage provides another benefit for astute retail investors. Pricing mismatch opportunities exist in Chinese companies. The U.S. market is the most closely watched market in the world. Chinese markets in comparison get far less attention. Risks exist, but the pricing mismatch presents opportunities that simply wouldn't exist in American markets.

But investors don't need to make their portfolios Chinese-centric. They can just as well choose only a few high quality Chinese names for the diversification they bring. Chinese markets remain some of the most insulated in the world. And though the American and Chinese economies are inextricably linked, most American businesses have not managed to enter those markets. This means Chinese stocks are some of the only ways to gain exposure to the Chinese economy.

Finally, the CCP declared it plans to transition its country from a manufacturing economy to a consumer and services economy like in the West. And it hopes for the GDP per capita growth that comes with that.

Find out more: Should You Add ADRs to Your Portfolio?

How Investors Can Invest in China

If you decide to take the plunge, you are probably wondering what the best way is to get Chinese exposure in your portfolio. After all, we already discussed China's unique dual-share system that doesn't allow investors to invest directly in locally listed businesses.

Thankfully, there are ways around this. As mentioned before, an exception exists for very large financial institutions such as those that manage large exchange-traded funds (ETFs). The most well-known for Chinese stocks is the iShares MSCI China ETF (MCHI), managed by Blackrock — the largest asset manager in the world.

Such ETFs track the Shanghai Stock Exchange's daily movements. And they give investors the benefits of exposure to the Chinese market while also diversifying the risk of investing in individual Chinese stocks. Or buy an emerging markets ETF in which Chinese stocks hold an outsized weighting.

Investors can also choose to pick individual stocks. We mentioned that Chinese stocks that trade on American exchanges make use of the controversial VIE structure. But the largest names out of China also have proven international business records. So the risk of fraud is much lower than with the average Chinese company.

That being said, risk exists — however small it may be — that the Chinese government intervenes in these VIE structures or mandates that they be shut down. This allows investors one other option: the Hong Kong Stock Exchange. The Chinese authority has allowed dual listings in Hong Kong (what are referred to as H-shares) in order to attract foreign capital.

Further reading: How to Invest in Foreign Stocks

Is China a Sleeping Dragon?

Investing in China poses plenty of risks, but it's hard to ignore the potential in the country. For long-term investors, holding a portion of their portfolio in large Chinese companies may provide some much needed diversification as well as a hedge against future American underperformance.

More adventurous investors may be interested in deep-dive research on individual Chinese stocks that may be underappreciated by fund managers and may provide handsome returns.

Chinese stocks however still have the same risks and volatility that is associated with emerging markets. As such, investors should not allocate a majority of their portfolio to the region.