There’s a huge change coming to China, and it could mean big stock returns if you own the right companies.
I’m talking about China’s reopening.
In response to widespread public protests by citizens frustrated after years of being locked down, the Chinese government recently announced it’s reversing its zero-Covid policy to unshackle the economy.
Two questions immediately come to mind. Is this really going to happen? And how big an impact will the change have?
I checked in with fund managers who specialize in China to find out.
“It’s real because it’s from the top,” says Haicheng Li, a portfolio manager at the Chautauqua International Growth Investor Fund
“They realized it cannot keep going on like this.”
One risk is that cases spike and hospitalizations get overwhelmed. But Li doubts this will happen because omicron is relatively mild.
I think Li is worth listening to because her fund beats competitors in its Morningstar foreign large-cap growth category by five percentage points annualized over the past five years.
Next, how much extra growth will the change produce? It could add three percentage points to yearly growth, taking annual GDP up to 5%-6%, says Charlie Wilson, portfolio manager at the Thornburg Developing World Fund
“From a Western perspective, when we were at peak Covid, that was really a partial lockdown because our essential workers were allowed to leave their homes. Some parts of economy benefited from the change,” says Wilson. “In China, it is actually very different. When they lock down, they lock down everything. You couldn’t leave your house. Delivery drivers could not leave their homes. There were a lot of services completely unavailable. That had a dramatic impact on economy.”
How big might your stock returns be if you buy into this trend? Here is one guide. Eight U.S. reopening plays I suggested on March 17, 2021, in my stock letter (the link is in the bio, below) were up 71% three months later vs. 27% for the S&P 500
My list included names like Churchill Downs
Royal Caribbean Cruises
and Home Depot
I can’t guarantee you’ll get the same results now with China, but here’s a group of names that analysts singled out as some of the best plays on China’s reopening.
Focus on two types of companies
It’s best to think of two categories of reopening plays, says Wilson at Thornburg. 1. Companies that benefit directly from reopening because people are out and about, and are interested in spending because they’re more certain about their incomes. 2. Economically sensitive companies that benefit generally because growth picks up. Let’s start with a few names in the first category.
Fast food chains and consumer companies
“Covid battered China’s food-service industry,” says Bank of America analyst Sara Senatore. Sales fell 5% this year, according to government data, but based on company reports she thinks the decline is worse. China’s food-service industry is the biggest in the world, at $781 billion in 2021 sales, compared to $591 billion in the U.S. So, sales improvements in China as Covid restrictions lift can really move the needle for investors.
6,600 China stores accounted for around 11% of 2021 sales and about the same portion of cash flow. They generated just 25% of a normal year’s cash flow this year — which tells us that reopening could have a big impact on results. Next year, assuming reopening holds, China will account for 36% of store growth, says Senatore.
which operates popular KFCs in China, will also get a big boost from reopening, says Wilson at Thornburg. That could push the stock a lot higher.
Think of it this way. At the end of 2019, the company had 9,000 stores there. By the end of this year, it will have around 13,000 stores. That’s nearly a 50% increase in earnings power, but the stock is up only 26%, trading recently at $57 compared with $45 in 2019. This analysis doesn’t account for the benefit of greater efficiencies at newer stores, says Wilson.
As in the U.S., Covid created a lasting growth in the popularity of food delivery. This favors larger established brands such as Starbucks and Yum China, says Senatore at Bank of America. Wilson likes the food-delivery company Meituan
as a play on this theme.
Li, at the Chautauqua International Growth Investor Fund, thinks the following two companies will benefit as people circulate more in public and are more confident about their incomes. One is the French luxury goods company Kering
which has brands like Gucci, Balenciaga, Bottega Veneta and Yves Saint Laurent. Also consider Sinopharm
which distributes products to retail drug stores.
The Chinese internet sector has matured, so companies in the space can no longer significantly outgrow the economy, says Wilson. But they got hurt by lockdowns, which cut into deliveries, and the economic slowdown, which hurt online ad spending, and consumer confidence and spending.
Four to consider here are the e-commerce platforms Alibaba
; search-engine company Baidu
; and online and mobile game company Tencent
They’ll all benefit as growth picks up and consumers spend more, delivery services get back to normal, and business advertising picks up.
Using a sum-of-the-parts analysis, Li thinks Alibaba shares are worth $140. They recently traded at $91. Pinduoduo, the third-largest e-commerce platform in China by merchandise volume, gets a four-star rating (of five) at Morningstar in part because brands continue to join the platform, boosting sales growth prospects, says Lorraine Tan, director of Morningstar’s equity research in Asia.
Li likes shares of the investment group Prosus
for exposure to Tencent. The value of its Tencent holding was recently worth more than the value investors assign to Prosus itself.
Baidu gets a five-star rating at Morningstar because ad revenue will pick up as the economy expands. It is currently trading at a forward price-to-earnings multiple of 11.2 times compared with 22 before the pandemic. It is also boosting profits by shifting away from business lines that dilute margins, including autonomous driving, says Morningstar analyst Kai Wang.
As for cyclical plays, Wilson at Thornburg singles out Chinese banks. They trade at all-time-low valuations of 0.2-0.3 times book value, compared with a historical range of 0.5 to 1 for large-cap banks.
“What’s embedded in the stock price is a very dismal outlook,” says Wilson.
Investors are worried that low growth will lead to rising non-performing loans. But Wilson questions that thesis because China is stimulating its economy, and because of the reopening. Not all banks have exposure to China’s struggling property market.
Wilson favors China Construction Bank
which trades at 0.3 times book value.
“You could easily get back to 0.6-0.7 times book value,” he says. “That is not a demanding valuation.”
Meanwhile, the bank pays a 9.6% dividend yield. Another one he likes is the Postal Savings Bank of China
which pays a 7.1% yield. Note that there is a 10% withholding tax on dividends from companies in China and Hong Kong, says Wilson.
Li, at the Chautauqua International Growth Investor Fund, singles out the French airplane engine manufacturer Safran
She says 18% of the company’s engines go into planes used in China. That means it will benefit from both stronger growth overall, and increased travel due to the easing of Covid restrictions.
If you screen on your own for companies with China exposure, be careful of two pitfalls. First, while tech companies like Texas Instruments
come up as having a lot of exposure to China, this is a mirage. Their components are sold to Chinese manufacturing companies, but the final products they’re in, such as smartphones, are sold primarily outside of China.
Next, be wary of companies with big China exposure when they also do a lot of business in parts of the world suffering from low growth, such as Europe. Wilson cites Nike
as an example.
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned SBUX, YUMC, BABA. Brush has suggested CHDN, PLNT, RCL, FUN, HD, SBUX, YUMC, BABA, TXN and QCOM in his stock newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.