By David Stevenson –

The ‘next great superpower’ has gone from hero to zero in the space of just a few years. The China bears are now rampant and even my great old Aunt Hilda reckons that China is a credit-fuelled napalm bomb ready to explode! Boy these eighty-year-olds have a turn of phrase!

The potential inclusion of A shares in global indices could be catalyst to turnaround the fortunes of unloved Chinese equities.

If we track asset flows, China is about as unpopular as you can possibly get – tens of billions of dollars have been flooding out of Chinese equity mutual funds and ETFs into Japan, a fact that can’t have gone unnoticed by China’s benevolent and ever so nationalistic leaders!

Even Chinese investors have been demonstrating their ‘unswerving loyalty’ to the motherland by shipping unprecedented amounts of money offshore…or frankly anywhere but deposited in low yielding local savings accounts.

Lurking in the back ground is the BIG debate about the slowing rate of Chinese growth. At the end of last year of every year, everyone was worrying about 7.5% GDP growth rates, then it was 7% and now the bears have red pens out and are marking in 6%.

Luckily the Chinese authorities don’t appear enormously rattled at the moment and in fact seeming to be taking this unpopularity in their stride, busily enacting a whole slew of regulatory and capital reforms designed to make the economy work better.

But the bad news is that Western investors have all but abandoned the local Chinese stock markets, unimpressed by increasingly bizarre local share class rules and dreadful corporate governance. Even Anthony Bolton has just this week announced that he’s throwing in the towel on his Fidelity China fund – is this the final sign of a capitulation?

Perhaps not! I have a sense that Chinese equities could head even lower in the next few months. Looking at a stack of recent reports from the pointy heads at the big London investment bank research desks, we can see that Chinese equities remaining HUGELY unpopular. Take Morgan Stanley – at the beginning of June they ran their annual Global Investment Seminar which involved key institutional participants answering a series of key questions, most importantly “what is your preferred equity region for the next 12 months?” European markets were by far the biggest winner at 49% of all votes cast, with the US coming in at 23% and Japan (more on that country next week) at 19%. Poor old China lagged behind at a miserable 6%!

A cursory look down the long list of recent technical and fundamental data provided by quant analysts at French bank SocGen paints an equally depressing picture. Chinese stocks are down 13% over the last year with 2012 PE ratios at between 7 and 8 depending on your market or index, falling to just over 6 if you believe 2014 estimates. Those numbers are despite earnings per share growth expected to come in at 11.5% per annum in 2013 and a dividend yield on the market of between 4 to 4.5%. In fact, largely unnoticed by Western investors, China has been quietly turning into a dividend-focused market. Perhaps the most staggering number is that Chinese equities currently trade at 1.1 times book value.

So Chinese shares are cheap, but I suspect they’ll be getting even cheaper over the coming months. China is in profound bear territory and there’s little sign that it’s about to change overnight.  For a contrarian like me, this long list of solid fundamentals, dreadful technicals, and annoying government interference starts to add up to an increasingly convincing bullish, albeit contrarian, case. I can’t see any imminent market bottom, but I can absolutely believe that now is the time to start researching direct exposure to China. It may even be the time to start drip feeding money in to the country on a regular basis to take advantage of dollar cost averaging.

And if we look even further there is a powerful positive catalyst lurking on the horizon. Only last week for instance, analysts at Deutsche Bank provided an answer as to why contrarians might start buying – Chinese shares will increasingly feature in major indices, which will in turn be tracked a host of ETFs and passive mutual funds. In their latest special report entitled “China Equity Market Opening up to the World” from 12 June 2013 they observed that index firm MSCI has announced that “it will include China A shares in the review list for potential inclusion to its most tracked global benchmarks such as the Emerging Markets (EM) index. These global indices currently include only some of the Chinese corporate shares listed overseas and B-shares listed in China. MSCI will announce its decision in June 2014. If MSCI decides to include China A shares (likely in a phased approach), the first change could be implemented as early as May 2015”.

On paper this all sounds about as exciting as watching paint dry, but Deutsche is spot on when they observe that “the inclusion of China A shares [is] a milestone in the indexing world with significant and long-term impacts  [my emphasis]. The Chinese domestic equity market is the third largest in the world by total market capitalization. However, China remains underrepresented among global investors’ portfolios, mostly due to the foreign investment restrictions of A share market. In addition, current global benchmarks do not have a good representation of the sector composition shown in the A share market”.

The killer observations from Deutsche comes next,”We expect the foreign holdings of A shares as percentage of total A share market cap to reach 4% in 2016, from current 1.5%. Assuming a full inclusion of China A shares, China’s weight could increase from current 18% in the MSCI EM to almost 30% (from 2.4% currently to 4.2% in the MSCI ACWI). Based on the estimated assets benchmarked to major global indices (assuming these assets will be allocated according to the country weight in the indices), China could witness inflows of over US$180bn. In the medium to long term, Chinese equity market has plenty of room to grow, which could potentially attract US$500 bn to $1500 bn inflows”.

The big question then becomes how to actually implement a strategy of slowly buying into local equities. The big challenge for any western investor is that active fund managers are – by and large – pretty dreadful at adding value. That means you are probably best using an ETF, especially one that follows the right index at low cost. Fees typically range from about between 50 and 80 basis points. The bad news is that, although there are plenty of China ETFs, a lot of them do much the same and track H-Shares (i.e. Chinese companies incorporated in Mainland China but listed in Hong Kong). Among the biggest listed in Europe are the iShares FTSE China 25 ETF (FXC) at 74 basis points and the Lyxor ETF China Enterprise (HSCEI) (ASI) at 65 basis points.

For A-share exposure, you need to look to the db X-trackers CSI 300 ETF (XCHA) linked to the CSI 300 Index at 50 basis points. Personally, however, I’m more drawn to specific sector plays around this A-share index. In particular, I like Deutsche’s A-share consumer discretionary and bank sector ETFs, namely the db X-trackers CSI 300 Consumer Discretionary UCITS ETF (XCHD) and db X-trackers CSI 300 Banks UCITS ETF (XCHB) respectively.

For more information on these visit: db X-trackers lists China CSI 300 sector ETFs on Deutsche Börse and Chinese consumer ETFs well poised as China’s leaders look to boost domestic consumption.