The recent sell-off in Chinese equities may have inspired some investors to go value hunting. The Chinese equity market is fascinating. This is a country that has experienced explosive growth over the past few decades - one of the greatest economic stories of all time. Yet, the financial markets are still relatively underdeveloped.
In a recent lecture, Chinese value investor Li Lu (Trades, Portfolio) noted that Chinese equity markets are still playing catch-up to the U.S. markets. Regulators are looking to instigate some significant changes to increase investor protections and investor interest.
Not only are Chinese equity markets changing, but the region's financial system is also still developing. The insurance industry is a great example. Life and non-life insurance penetration in the United States is around 12%. However, in China, it is less than 5%. In a country with a population of more than one billion citizens, these figures suggest there is still a potential market of more than 70 million consumers for Chinese insurance companies to reach. This is only one part of the financial industry.
I have used these figures to highlight just how big the opportunity is in China. But as any emerging markets investor will tell you, having a large potential market is one thing. Making money from this market is another thing altogether.
Finding Chinese investments
Finding investment opportunities in the Chinese market is the hard part, especially for foreign investors who have little to no insight into how the economic situation differs from what they are used to.
We can look back at the advice of Benjamin Graham in order to provide a strategy that may prove helpful. After all, back in Graham's day, the U.S. market was still very much in the early stages of capitalism.
A core principle of Graham's strategy was to buy stocks at such a low valuation that investors may be able to avoid significant losses if something went wrong. He called this his margin of safety, and it is something Warren Buffett (Trades, Portfolio) went on to develop and adapt to the modern day.
At the 1999 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting of shareholders, Buffett was asked by an investor if he had given any thought to Chinese stocks. He responded by saying:
"Well, I don't know that much about them. But if I could buy companies that were earning 20% on equity and had the promise of being able to continue to do that while reemploying most of the capital, and they were selling at five times earnings, and I felt good about the quality of the earnings, you know, I would say that would have to be an interesting field."
Some investors may argue that Graham's principles for investing are out-of-date, and I would agree to a certain extent. However, I can really see some value in pursuing a strategy based on his principles here.
If one can find a Chinese company that is able to earn high returns on capital and can earn high returns on reinvested capital, trading at a discount valuation, then the odds of the trade working out are greatly improved.
The one caveat here is finding a company where there is a high level of visibility over earnings growth and reinvestment potential. For the average investor, this may be challenging. Most U.S.-based investors don't have detailed knowledge about the Chinese market, which can be confusing for Western investors. It is for this reason that I am not particularly keen on buying individual Chinese equities myself.
I think the companies will experience strong growth as the country advances and its financial markets develop, but I don't understand the economic situation. As such, I would rather outsource my investment decisions in this region to those that do. It is not the perfect approach, but very few investment decisions are black and white. It's all about finding the right balance.
Put simply, investors who are comfortable deploying capital into the Chinese market may benefit from following a Graham-Buffett-inspired approach of buying high-quality stocks at bargain-basement prices. For investors like myself, I'd still recommend index funds or steering clear of the market entirely.
