Ways to avoid the cracks in China

Were it not for rubber bullets on the streets of Madrid and a US presidential election campaign building a head of steam, China would surely be getting more attention than it has.

The dramatic fall from grace of former political high-flier Bo Xilai, the two-week walkabout of leader-in-waiting Xi Jinping, rising tension with Japan and the launch of the country's first aircraft carrier mean the run-up to November's leadership transition could hardly be more fascinating - or worryingly uncertain.

Meanwhile, for investors in the Chinese stock market, 2012 has been yet another extremely disappointing year. The Shanghai Composite index stands around 12pc lower than a year ago, has lost a third of its value in three years (as the chart shows) and two thirds against its pre-crisis peak.

The shift in sentiment has been dramatic. Some of those attending the recent World Economic Forum meeting in Tianjin, a fast-growing port city half an hour by high-speed train from Beijing, were struck by the note of pessimism and cynicism about China's prospects.

It is all a marked contrast to the feeling in the immediate aftermath of 2008's financial crisis that China could single-handedly pull the developed world back from the abyss. And it begs the question of whether economists and investors are being as irrationally gloomy as perhaps they were overly optimistic before. It matters because no one wants to be the dumb foreigner backing the China miracle even as the country's own residents are heading for the hills.

One reason to believe the pessimism may have been overdone is the traditional investment splurge that has followed leadership transitions ever since the new market-oriented regime began following the death of Mao in 1976.

With growth in economic output having fallen to its lowest rate in 20 years, there is plenty of incentive for the government to crank up spending again after the leadership congress has rubber-stamped the new establishment. Provincial and city governments have begun unveiling ambitious spending plans.

The second reason to think that the Chinese equity market has over-reacted is the extreme valuations starting to emerge. According to Citi, the rate of earnings growth implied by today's stock prices in Shanghai is the lowest in the region at just 0.6pc a year. That compares with 6pc in India and Indonesia and 7.5pc in the Philippines.

The average multiple of earnings at which Chinese shares trade is also standing at a historically high discount to the price/earnings ratios in Hong Kong and the rest of the Asia-Pacific region excluding Japan.

That seems unfair given that Chinese companies are just as profitable as their counterparts elsewhere. Either returns in China are not sustainable or they are being mispriced. Clearly, valuations are not the main issue in China. More important is sentiment, which appears to be approaching the capitulation stage where investors have fallen so out of love with a country or asset class that they just want out whatever the price. A quarter of investors in a recent Bloomberg poll said they expected China to be among the worst performers over the next year. It is interesting how often investors' expectations of future returns are simply an extrapolation of the recent past and how often this turns out to be completely wrong.

Fund flow data confirm the deterioration in sentiment. According to EPFR, a data company, fund managers are reining in China holdings as rapidly as they did in 2008 when Shanghai shares made a mockery of the idea that emerging markets would decouple from their developed world counterparts.

So, a reasonable contrarian case can be made for investing in Chinese shares. They are cheap versus history and compared with other markets while the government has both the incentive and the firepower to continue easing. Inflation is not a problem, interest rates are higher than any country in Asia bar India and public debts as a proportion of GDP are lower than anywhere except almost debt-free Hong Kong.

It is a reasonable case but not an overwhelming one as long as sentiment remains so poor. I think any long-term investment portfolio should have an exposure to China - mine certainly does - but Chinese shares are not the only way to invest in the country's growth.

Big Western companies with extensive operations in or selling to China look an attractively low-risk way of gaining that exposure today.

Tom Stevenson is an investment director at Fidelity Worldwide Investment. The views expressed are his own. He tweets at @tomstevenson63