MCHI: Chinese stocks remain undervalued with cyclical upside potential (NASDAQ:MCHI)
Presentation of MCHI
iShares MSCI China ETF (NASDAQ:MCHI) is an exchange-traded fund that allows investors to gain exposure to Chinese equities; medium and large caps. The fund was launched on March 29, 2011 and its current benchmark is the MSCI China Index. As of February 10, 2022, net assets under management were $6.64 billion, reflecting fairly high popularity.
As shown below, fund flows have been positive for the past year or so; MCHI received approximately $1.79 billion in net inflows.
MCHI and sense of risk
I’ve been both bearish and bullish on MCHI, most recently bullish, and it’s been mostly valuation-based. However, it is always worth reviewing as the data may change. In a sense, it is quite perverse to invest in a stock market whose governance of the country is communist, although the CCP (Chinese government) has borrowed concepts and structures from capitalism to help sustain the past decades of growth ( especially since the turn of the 21st century). Nonetheless, given the country-specific risks, Chinese equities will likely still be considered risky.
As a result, not only are equity risk premia likely to be higher, but the volatility of the equity risk premium for China is also likely to fluctuate. ERPs directly affect valuations. The volatility of the implied Chinese ERP, or more precisely the implied “cost of equity”, is likely to increase during periods of global risk aversion, as well as during periods of unrest and political uncertainty in Asia. -Peaceful. China-Taiwanese relations are an ongoing source of investment risk.
In any case, while MCHI’s curve has been positive since the fund’s inception (on the whole), risk sentiment has recently been negative if price action is any indication. The chart below illustrates the price performance of MCHI since the fund’s inception in the first quarter of 2011.
Since inception, the price of MCHI shares has actually changed little (up 20.60% over almost 11 years, an annualized price return of only 1.74%). However, buying at the local low was a relatively good strategy in the short to medium term, as the fund was able to continue making new highs over time after each cyclical low.
Cyclic positioning of MCHI
In addition to the cyclicality of the MCHI stock price itself, we need to understand the fund’s cyclical exposures in terms of sectors and the Chinese economic cycle. Starting with the latter, Fidelity research suggests that the Chinese economy (as of Q4 2021) is likely entering a contraction or recession phase. This is based on factors such as lower business activity, possibly lower credit creation resulting in higher credit creation (and attempts to ease/easing monetary conditions) and lower corporate profits (following lower sales and inventory).
However, if stock markets are a leading indicator, then MCHI’s rise could be in store, if the recession has already been fully priced in after the recent declines. After the recession, you have the first part of the next short-term economic cycle to wait (potentially). Timing is always an issue, but with MCHI shares well off their highs (30%-40%), there could be an opportunity.
MCHI’s sector exposures favor cyclical economic rebounds; as illustrated below, approximately 53% of MCHI’s portfolio is invested in a combination of basic materials, consumer discretionary, financials and real estate. These are all sectors that Morningstar categorizes as cyclical, so upside volatility could be high if/when China starts to move forward economically (after the recession). Additionally, Fidelity research suggests that Western economies such as the United States lag China in their business cycles; thus, diversification into potentially undervalued Chinese (and APAC) territories could prove a profitable strategy.
Short-term valuation of MCHI
Morningstar puts the potential three- to five-year earnings growth rate for MCHI’s portfolio at 9.76% at present. We can apply this to the underlying earnings implication provided by MSCI using a recent fact sheet for the MSCI China Index on which MCHI’s capital allocation decisions are based. As of January 31, 2022, the MCHI index had a price-to-earnings ratio of 13.70x, a forward price-to-earnings ratio of 11.71x and a price-to-book ratio of 1.62x. So the forward earnings yield was around 8.54%, which is quite high, especially since Chinese interest rates are not that far off from Western rates.
For example, the yield on Chinese 10-year bonds was recently 2.794%; which compares to the US equivalent of 1.939%. The current equity risk premium for mature markets could be around 5.17% (in February 2022). And using Professor Damodaran’s Country Risk Premium data, China probably deserves an additional premium of around 0.59%. This may underestimate the risk, but we can use this as a baseline. By adding the ERP of mature markets over 10 years and the country risk premium, we arrive at an implicit MCHI cost of equity of 8.554%. Using all of this data, I arrive at the following short-term assessment.
My estimate of the potential upside is around 38%, roughly in line with my last estimate at the end of November 2021. Since then, MCHI shares have fallen slightly, but so have virtually all major stock markets recently until ‘in 2022. I think the valuation here would suggest that there is still upside potential and that even with interest rates higher than prevailing, we are unlikely to see a prolonged bear market in global stocks.
The reason is that current valuations already seem to imply higher long-term rates. On the above valuation, which includes not unreasonable earnings growth rates, to resolve fair value (0% up or down from the current MCHI stock price), we would need to increase the cost of equity from 8.55% to 11.61%. So, in theory, the Chinese 10-year could climb as high as 5.85% before the fund starts to look overvalued (which would be a very large and unlikely rise in interest rates). Either that or investors are valuing a much higher country risk premium, but that risk factored into the market is potentially an individual investor’s profit (if one holds MCHI shares long-term, and assuming country-specific risks are mostly unfounded).
I like the cyclical nature of MCHI’s price action, and think that overall the stocks remain undervalued. While Chinese equities should definitely be considered further off the risk spectrum for most investors, I think the Chinese stock market is quite an interesting way to diversify internationally and capture some alpha /outperformance, as the Chinese economic cycle remains ahead of the West. (asynchronously).