By Clement Tan
HONG KONG, Dec 18 (Reuters) - Chinese shares may be poised
to become an unlikely star of Asian emerging markets in 2014,
outshining India, thanks to cheap valuations and optimism about
Investors have been underweight China for years.
China-focused equity funds saw some net inflows in November,
when the ruling Communist Party announced plans for far-reaching
economic and social reforms, and analysts said once the
government starts following through on those plans it would
trigger a flood of money.
Foreigners have bought a net $18.8 billion worth of Indian
shares this year, according to the market regulator's data.
Official statistics are not published for China, but data
from fund tracker EPFR shows a net $5.5 billion outflows for the
year to Dec. 11 for China-focused equity funds.
At 9.3 times forward 12-month earnings, the MSCI China
is trading at a chunky discount to its 10-year median
and at its widest gap to the MSCI Asia ex-Japan
since the 2008 financial crisis.
And the Chinese market is trading at a 40 percent discount
to MSCI India on a forward price-to-earnings
basis, according to Thomson Reuters I/B/E/S data.
In contrast, benchmark indexes in India have hit record
highs and valuations are on par with 10-year averages.
Besides looking expensive, Indian shares could also be
vulnerable to shocks that could come from the U.S. Federal
Reserve winding down its stimulus, current account problems, and
a general election due by May next year.
At the very least, investors look unwilling to add more
Indian risk and will look to make fresh allocations next year in
other markets, with China firmly on their radar.
"Overall, we believe Chinese equities are just too cheap to
be ignored by investors in 2014," said Desmond Tjiang, Greater
China and Hong Kong equities portfolio manager at Pinebridge
Investments in Hong Kong.
"Despite reforms and the broad economic slowdown, there are
still a lot of industries such as mass consumption, e-commerce
and environment-related sectors that should continue to grow
exponentially in the coming years."
Beijing last month unveiled a bold reform plan, including
pledging to free up markets, in a bid to put the world's
second-largest economy on a more stable footing.
The plan sparked a rally in Chinese stocks that saw the
offshore Chinese market in Hong Kong gain more than 10
percent in four sessions, before levelling off.
Some brokers, such as CLSA, said the rally lacked conviction
due to an absence of institutional investors. But while some may
still be wary of a market that has been in a funk since 2007,
there are signs things could be turning around.
In a Nov. 21 report, Goldman Sachs said funds focused on
global emerging markets and Asia were underweight China by 290
and 582 basis points respectively, suggesting a return to equal
weighting alone would trigger a powerful rally.
"India may have more upside potential in the short term
because markets may rally into the elections due in May, but
China represents better value in the middle term," said Angelo
Corbetta, Pioneer Investments' London-based head of Asian
PLAYING CHINA SMART
But India's potential is starting to look stretched on
valuations already. Information technology and pharmaceutical
companies, which led stock indices to record highs last week,
The MSCI India IT sub-index trades at 21
times earnings forecasts for the year ahead, well above the 12
times for the equivalent index for Asia-Pacific countries
outside of Japan. The MSCI health care
sub-index is starting to look similarly
In comparison, China Inc's earnings revision ratio -- the
pace of earning forecast upgrades against downgrades -- has
turned around, suggesting investors think Chinese companies'
earnings prospects are improving.
"For three years, markets have been betting on a hard
landing in China. It is time to unwind some of those bets," said
the head of a Asian macro hedge fund in Hong Kong.
For the rally to last beyond early 2014, investors will
expect clear steps to be taken to resolve Chinese banks' bad
debt problems. They will also want to see how the reform drive
will impact corporate margins and earnings, especially for giant
"We will be looking for a dramatic improvement at the
operating cash flow level at the next earnings. Most Chinese
companies have negative working capital, which means they are
subsidising their clients," Pioneer's Corbetta said. "It's all
about allocating capital more efficiently."
If that happens, Chinese equities may well see a re-rating
in the longer run.
"If China gets its reform right...we will move into an
environment where we don't just buy the dip and sell the bounce,
but you actually just buy the dip because the long-term
trajectory is positive as opposed to flat to down," said Andrew
Swan, Blackrock's head of Asian equities, told the Reuters
Investment Summit in late November.
(Additional reporting by Saikat Chatterjee, Vikram Subhedar in
HONG KONG and Abhishek Vishnoi in MUMBAI; Editing by Simon