Foreign investors have started rebuilding their China equity portfolios, tempted by low valuations after two years of market underperformance and signs economic growth may be stabilizing.
They have pumped nearly $4 billion into Chinese equity funds in the past two months alone, trying to get in early on what they hope will be a sustained rally.
But sentiment looks to be running ahead of fundamentals. There are clear risk signals for the Chinese market -- including sluggish earnings, rising corporate debt and retail investors looking for other opportunities -- even if the broader economy gathers strength.
"Valuations are attractive and fears of a major slowdown in China seem to be waning, while China still promises growth faster than the rest of the world," says Paul Gillis, professor at Peking University's Guanghua School of Management.
"But most of the problems affecting Chinese stocks -- accounting fraud, the variable interest entity and regulatory stand-offs between the U.S. and China -- have not gone away and still need to be solved."
Illustrating that growth does not translate into equity gains, the MSCI China stock index has fallen more than 40 percent since its launch in 1992. Over the same period, China's nominal GDP has increased by 15 times.
The shift in foreign investor attitudes is clear.
Bank of America Merrill Lynch's global survey of fund managers, covering 248 managers with $695 billion of assets under management, found confidence in China's economy was at a three-year high.
In October, Chinese shares listed in Hong Kong, known as H-shares and the main gateway for foreign investors into China, jumped 7.6 percent to easily outpace other regional benchmarks.
"I think most fund managers are looking at the fundamental mismatch in their portfolio between their direct exposure to China and the role China plays in the global economy, often very little versus one hell of a lot," said Michael McCormack, executive director at China-focused fund consulting firm Z-Ben Advisors.
"Investors are now trying to rebalance that."
One attraction is valuations. The MSCI China index, the most popular benchmark for China funds, has consistently underperformed Asian markets over the past two years, following a stellar run where it nearly tripled in value between October 2008 and November 2010.
The index trades on a forward price-to-earnings multiple of 9.2, cheaper than Brazil on 9.9 and India on 13.2, and a lure to investors hoping to get in early on another substantial upswing. The H shares are at price-to-book ratios around four times lower than in 2007, according to Thomson Reuters data.
Those valuations and signs the economy is improving -- Thursday's flash PMI reading showed the first expansion in manufacturing in 13 months -- have piqued interest, and it seems investors are worried about missing out on riding the recovery.
Data from fund-flow tracker EPFR Global shows inflows into China equity funds accounted closed in on $4 billion over the 10 weeks to mid-November, and accounted for more than half of the flows in Asia ex-Japan funds in the week to November 15.
"[The Chinese market] has bottomed out and found a new level, so people don't want to be negative about China anymore," said Stuart Rae, chief investment officer of Pacific Basin Value Equities at AllianceBernstein.
The company's $879 million Asia ex-Japan fund, launched in November 2009, is now overweight China for the first time, said Rae, who also manages its US$150 million QFII China fund.
As Beijing's new leadership settles in, the stock market's fundamentals are back in focus and they could make the recent enthusiasm seem premature, said Simon Grose-Hodge, head of investment advisory for South Asia at private bank LGT.
For one, there is unlikely to be a repeat of anything remotely like the 4 trillion yuan ($640 billion) stimulus package that guided the Chinese economy through the 2008/09 global financial crisis.
Instead, there may be smaller, more targeted spending plans that don't make cheap credit available across the board.
And longstanding issues for investors, such as transparency, reform of state-backed companies, corporate governance and regulator interference in the market, have yet to be properly addressed despite some positive noises from authorities.
So while the H-shares in Hong Kong are showing signs of life, China's domestic stock markets are languishing near three-year lows and on the nose with retail investors.
Two-thirds of Chinese companies that have posted third-quarter earnings missed expectations, according to Citi Private Bank. Profits fell an annual 5.8 percent, and analysts, on average, are still cutting earnings expectations for next year.
Leverage has soared above comfortable levels, with Beijing-based consultancy GaveKal-Draganomics expecting corporate debt to hit 122 percent of GDP by the end of the year, up from 108 percent at end-2011.
Rising non-performing loans (NPLs) pose a risk for the banks, a hangover from cheap credit as part of the 2008/09 stimulus. Goldman Sachs & Co estimates the NPL ratio is more than six times the official reported rate of 0.97 percent.
Further, China's industrials were owed more than 8 trillion yuan in net receivables at the end of September, up 16.5 percent from a year earlier, according to the National Bureau of Statistics.
HSBC says the annual pace of profit growth of non-financial companies in the CSI 300, which tracks the performance of China's A-share market, has been falling for the last three quarters, while the quality of earnings -- measured as the ratio of free cash flow to net profit -- is in negative territory.
The CSI300 is down 7 percent this year, following a 25 percent drop in 2011 and a 12.5 percent fall in 2010.
"Five years back in 2007 the (Chinese) market was one of the most expensive and now it's cheap on a par with Korea -- it's one of the cheapest markets in Asia," said Pacific Basin's Rae.
"There is lots of stuff that's cheap -- some has recovery potential but then some is cheap for a reason."
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