Investing in Chinese companies has never been easy for U.S. investors. Over the last couple of years, this exercise has become even more complicated as a result of trade tensions between the U.S. and China.
Things were taking a positive turn last December when the two nations signed a preliminary trade deal to reach some middle ground. In the last few weeks, however, the tensions have once again resurfaced due to geopolitical uncertainties. To add salt to the wound, Luckin Coffee (LK, Financial), the Chinese coffee giant that was expected to make it big in the coming years, revealed in April that one of their executives reported fabricated sales numbers. This malpractice has led many investors to question the numbers reported by all Chinese companies listed on U.S. stock exchanges.
The Senate passed a bill on May 20 that could lead to the delisting of Chinese companies if they do not meet certain accounting criteria. This bill attempts to address the inability of the Public Accounting Oversight Board to go through the audit paperwork of foreign entities, especially ones domiciled in China.
Amid this backdrop, Morningstar reported that investors have pulled more than $2 billion from exchange-traded funds that invest in Chinese stocks since March. This is a testament to the negative sentiment among American investors.
The attractive growth profile of the country, however, should not be ignored altogether. Careful scanning of the market and macro-level developments reveals one fund that could weather the storm well and deliver attractive returns to investors: the iShares China Large-Cap ETF (FXI, Financial).
The structure of the fund makes it a good play
In case the U.S. decides to kick Chinese companies out of its markets, most of these billion-dollar giants will likely choose Hong Kong as a viable alternative to raising capital. A change in listing regulations last year enabled a company to list dual-class shares on the Hong Kong Stock Exchange and to use the exchange for secondary issues. Alibaba Group Holding Limited (BABA, Financial) was one of the first companies to take advantage of this positive development. The Chinese e-commerce giant raised $13.4 billion last November by offering new shares in Hong Kong. Tencent Holdings Limited (TCEHY, Financial), another Chinese tech giant, went down the same path as well, and these two companies have set a new trend that could result in Hong Kong emerging as a top destination for East Asian countries looking to raise capital in international markets. The escalating trade tensions and the new bill passed by the Senate will help this trend gain momentum as well.
The iShares China fund exclusively invests in large-cap stocks that trade on the Hong Kong Stock Exchange. This makes the fund less susceptible to regulatory changes in the United States, even though trade tensions would still have an impact on the corporate profits of these companies and, therefore, the market value. However, investors could avoid a catastrophe by distancing themselves from the regulatory risk by choosing to invest in Hong Kong-listed Chinese stocks, and this fund is the ideal vehicle to serve this purpose.
The top 10 holdings of the fund include some of the largest Chinese companies that have shaped the economic growth of the country:
Source: BlackRock
The fund only invests in the 50 largest Chinese companies listed in Hong Kong, which reduces the risk of an investor betting on a small company that is yet to prove its resilience. An investment in the fund offers a cost-effective and efficient way to gain exposure to many companies. The below illustration plots the top sectors represented by this fund.
Source: BlackRock
At the closing market price of $40.34 on June 12, the iShares China Large-Cap fund offers a dividend yield of 2.96% as well, which is very attractive in this low-interest-rate environment.
The case for investing in China
China suffered its first economic contraction in 28 years in the first quarter of this year as the GDP shrank 6.8% as a result of the nationwide lockdown. The country, which plays a major role in the global supply chain, had to keep its manufacturing plants closed for the better part of the first four months this year. Even though this is not encouraging, the scale of the lockdown enabled China to become the first country to end its lockdown in April, and there are promising signs of a spectacular recovery. For instance, infrastructure investments in the country recovered in April after falling sharply through March, according to data from the National Bureau of Statistics. Retail sales gained momentum as well.
Source: National Bureau of Statistics/Caixin
Economists surveyed by Bloomberg estimate quarterly GDP growth will recover by the end of this year and converge with the historical trend.
Source: Bloomberg
According to these experts contacted by Bloomberg, the worst seems to be over for the second-largest economy in the world. This makes sense as the country was among the first few nations to lift mobility restrictions and order the resumption of business activities.
In the next couple of decades, China is likely to emerge as a global superpower, according to Ray Dalio (Trades, Portfolio), which paints a very optimistic outlook for the performance of publicly listed Chinese companies. According to PricewaterhouseCoopers, China will become the largest economy in the world by 2050, which is a confirmation of the guru’s beliefs. Going by these facts, ignoring the investment opportunities in Chinese stocks does not seem a prudent decision. VanEck's head of ETF products, Ed Lopez, told Barron’s, “They (China) are a massive economy; they’re influencing so much what’s happening in the world. It’s a market you just can’t ignore.”
To mitigate the regulatory risk of betting on the success of these companies, an investor may want to choose the iShares China Large-Cap ETF as an investment vehicle to gain exposure to this booming economy.
Takeaway
China is set to resume its growth story as the country slowly comes out of a lockdown that saw the majority of its manufacturing plants come to a standstill. Even though attractive investment opportunities are present, U.S. investors have pulled funds out of Chinese stocks in light of the escalating trade tensions between the two nations and the recently approved bill by the Senate. The iShares China Large-Cap ETF can help investors mitigate the regulatory risk and participate in the growth story of China that will likely see the country become the largest economy in the world in a couple of decades.
Disclosure: I do not own any shares mentioned in this article.
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