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Feeling adventuresome? Chinese stocks still hold a lot of appeal

Stock market investors are running away from China and it's easy to understand why. A nausea-inducing plummet over the past month has chopped the Shanghai Composite Index by a quarter, and Beijing has resorted to panicky, heavy-handed measures to reverse the slide, including a six-month ban on insider selling in many cases.

All of which means it's an excellent time to ask whether the fleeing crowds could be headed in the wrong direction. Is it possible that Chinese stocks might actually represent decent value at this point?

The question isn't as daft as it sounds. In a report last week, Goldman Sachs predicted that the Shanghai market could rebound by double-digit amounts over the next 12 months as government tactics to boost stock prices gain traction and valuations swell.

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Fidelity Investments, the giant U.S. mutual fund manager, also gushed about the potential of Chinese stocks in an interview with Bloomberg News on Friday. "We are fully invested," Robert Bao, a Hong Kong-based money manager at Fidelity, said.

Wilfred Hahn, CEO of Hahn Investment Stewards in Kelowna, B.C., argued in a note to clients this past week that it would be a mistake for investors to jump out of China's equity market despite the apparent crisis that is now unfolding.

"Chinese financial markets have only three speeds – boom, bust or comatose …" Mr. Hahn wrote. "The current volatility is hardly outside of historical norms."

Back in 2007 and 2008, the Shanghai Composite lost two-thirds of its value. More recently, Chinese stocks began a huge run-up in 2014, rising 163 per cent over 12 months. They then swooned 30 per cent over the past month, before staging a 10 per cent rebound over two days to finish the past week.

Volatility of that magnitude stretches nerves and upsets digestions. But it also holds the potential for profit if investors buy in at the right time.

The case for Chinese stocks right now begins with valuation. While many investors believe that price-to-earnings ratios are inflated to absurd levels in Shanghai, it all depends where you look.

The median price-to-earnings ratio in Shanghai stands at a lofty 57 even after the recent slide. That is almost three times as high as for the S&P 500 index in the United States.

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But the median P/E ratio – the point at which half of companies have lower P/Es and half have higher P/Es – is pushed up in Shanghai by the large number of smaller companies trading at stratospheric prices.

Larger, older, state-dominated enterprises tend to trade at much lower valuations. In fact, the average P/E multiple of the Shanghai Composite as a whole hovers around 19 – pretty much identical to levels in New York and Toronto.

In addition, Chinese stocks benefit from an economy that is probably – although not certainly – growing faster than North America or Europe. A property market downturn and credit concerns are weighing on growth and few foreign observers believe that the country will hit its 7 per cent target for GDP expansion this year. However, "the current pace of around 4 per cent or so, is still faster than any other major economy in the world," Mr. Hahn maintains.

On top of that, he says, it's likely that the widely used MSCI market benchmarks will add Chinese mainland stocks to their indexes over the next two years, triggering a large demand for the equities. In Mr. Hahn's view, investors should expect volatility, but remain steadfast in their commitment to Chinese equities.

Others aren't so sure. Much of the recent run-up was fuelled by borrowed money and Bank of America strategist David Cui believes selling pressure will "stay relentless" as investors scramble to dump stocks and pay back margin loans.

Even more worrisome is the possibility that the stock market slide signals deeper problems in China's opaque economy. The government's drastic moves to avert a stock market collapse can be read as an indication that it thinks the situation is fragile.

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However, for now, many of the worries seem overblown. Most early investors in the market are still sitting on big gains. Only a narrow swath of affluent Chinese households is likely to feel any real pinch from the recent setbacks.

"With only a small and relatively wealthy portion of Chinese households exposed to the stock market, we aren't particularly concerned about the impact of big falls in equity prices on consumption," Julian Evans-Prichard of Capital Economics says. "Indeed, given that the stock market didn't provide any noticeable boost to spending on the way up, there is no reason to expect it to be a drag on the way down."

Add it all up and Chinese stocks are still far from a compelling buy for conservative investors. But more adventurous investors with a long-term perspective should keep an eye on them, especially if the selling pressure resumes this week.

With files from Bloomberg News

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