Almost as quickly as the China stock rally happened, several investment analysts have been swift to point out its weaknesses. “China’s recent rally was not justified by fundamentals,” Citi’s emerging markets strategists said in a note Friday that downgraded China, while upgrading India. The firm is overweight Chinese internet, industrials and technology, but neutral on autos and consumer stocks broadly. Among the sectors, consumer discretionary stocks have the highest expected earnings per share growth this year of about 29%, the Citi report said. After a tepid start to 2024, the MSCI China Index is beating not only emerging markets but the S & P 500 with gains of nearly 11% year-to-date. “Although it looks like a big rally, it’s not broad,” said Ding Wenjie, investment strategist for global capital investment at China Asset Management Co., according to a CNBC translation of her Mandarin-language remarks. “The increase in capital is not as big as we expected,” she said, noting hedge funds rather than long-only funds were doing much of the buying — primarily in Hong Kong-listed consumer discretionary names in the internet tech sector. MSCI China’s top holdings are Hong Kong-listed shares of Tencent and Alibaba , which have both recently ramped up stock buybacks with their extra cash. “Our strategy has always placed great importance on free cash flow,” Ding said, noting a defensive aspect and how recent government capital markets policy has emphasized the ability of companies to buy back stock. Investors in China are increasingly focused free cash flow , an indicator on profitability which reflects how much money a company has generated, excluding operating expenses. The cash can be used to repay creditors or give investors dividends. Such signs of financial health are important in an economy whose growth is slowing after years of rapid expansion, China Merchants Securities pointed out in a webinar on the Wind Information financial platform last week. In an environment of moderating demand, relying on high levels of capital expenditure can no longer generate significant returns, the securities firm said. It’s now focused on finding industry leaders with high free cash flow. Earnings ahead Investors will soon get details on how the best-known names are doing financially. Tencent and Alibaba are due to release quarterly earnings on Tuesday, while Baidu is set to report on Thursday. Hong Kong-based AlphaHill Capital is looking specifically for Chinese consumer names with free cash flow growth, said Siliang Jiang, the firm’s partner and portfolio manager. He noted the narrative around China may have turned significantly gloomier in the last five years, but he does not expect China will repeat Japan’s “lost decades” due to its far larger market that can absorb the cost of research and development. Jiang expects the Chinese consumer will start to turn around in the second half of this year or next year. There are already a few green shoots. China’s “Consumer Confidence Index (CCI) edged up in the past 9 months, despite falling property prices and fears of ‘household balance sheet recession ‘. That said, the current CCI reading at 89 is still well below the pre-COVID levels at ~120,” Bank of America analysts said in report in late April. “We advise investors to focus on firms that can create value for consumers – value for money, functional value, and/or emotional value,” the report said. Two of their picks based on positive free cash flow are Li Auto and New Oriental Education . Based on their expectations of future cash flow, the analysts also like the Beijing-Shanghai High Speed Railway operator, a state-owned company listed in Shanghai. They noted its potential to hike prices while benefiting from an increase in travel post-Covid. Last week, Chinese media reported that many of China’s high-speed train operators will raise ticket prices by nearly 20% for certain routes, which include travel around Shanghai. State-owned transportation and utilities companies are able to increase their profit margins by raising prices in China’s current economic environment because they have monopoly power, said Liqian Ren, leader of quantitative investment at WisdomTree. The firm has an ETF for tracking non-state-owned Chinese companies. “How long this tactical rebound is going to [last] probably depends on the economic data in the next couple weeks,” she said. “Considering China isn’t stimulating too much, that means the Chinese economy is not as bad as [much] of the negative sentiment,” Ren added. China is due to release major economic data Friday local time on May 17. Analysts polled by Reuters expect a 3.8% increase in retail sales in April from a year ago. — CNBC’s Michael Bloom contributed to this report.
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