MCHI: Buy This ETF For Exposure To Chinese Growth

MCHI ETF, also known as iShares MSCI China ETF (NASDAQ:MCHI) is an ETF (exchange-traded fund) that tracks the MSCI China Index. It has fallen to $52.71 as of 8th March 2022, and actually reached a new 52-week low of $52.16 on the same trading day. With the massive sell-off in Chinese stocks over the past few months, this could finally be a decent buying opportunity. In this article, I will be explaining why this ETF, at its current valuation, could be a great way to gain exposure to high-quality Chinese companies.

The massive sell-off in Chinese equities

Over the past few months, we’ve seen a massive sell-off in Chinese equities. The sell-off itself was brought about by multiple factors, from the news of DiDi delisting (DIDI), to the Evergrande liquidity crisis, to the regulatory concerns with regard to Alibaba Group (BABA). Investors worldwide are starting to lose faith in Chinese equities, and the magnitude of the sell-off is getting out of hand. MCHI ETF is down about 46% from its 2021 high of $97.55. The magnitude of this drop is alarming, considering that this is an ETF which is meant to be less volatile due to its diversified portfolio. It is also noteworthy that MCHI ETF has not seen such prices since the earlier half of 2020. I believe that this sell-off has been way overdone, and we could definitely see this ETF regain its massive losses in the future.

The Chinese economy

With all the fear about China, people often overlook a few positive indicators with regard to the Chinese economy.

Economic growth

Since 1978, China’s GDP (Gross Domestic Product) has grown at an average annual rate of about 10%. In this same time period, much has been done to massively improve healthcare, education and technology in the country. It cannot be denied that China is growing massively in terms of its economy, and has already claimed its place as one of the largest economies in the world. If China continues its expansion, we could very well see this economic powerhouse take over many key sectors – the technology sector isn’t out of the question. Certain forecasts even predict that China would overtake the U.S. economy by 2030. The growth of China’s economy would mean great news for Chinese companies, which have all to benefit from it. We could very well see a huge increase in the valuation of Chinese equities in the long-term as the country’s economic development stays on trend.

Growing middle class

In 2000, the proportion of China’s population in the middle-income bracket was 3%. This same metric is over 50% today, which represents over 700 million people who are currently in the middle-income bracket. This is a clear sign that the country’s middle class has been growing massively, which gives rise to many economic opportunities due to a massive pool of consumer demand to tap into. With an increasing number of consumers with more disposable income, we could see an accelerated consumption of many goods and services. Chinese companies could realize huge economic gains as a result, as their consumer base and the demand for their products see a healthy upward trend in the long term.

Economic stimulus

China’s inflation rate is slowing down, and this has given the country sufficient room to embark on policy easing measures. Early this year, China has already declared that it would cut interest rates after economic growth has shown to be slowing down slightly in the late half of 2021. This is an expansionary measure to generate more economic growth through increased consumption. Compared to the U.S., which sees multiple rate hikes in the months to come, Chinese companies are in a much better position to become more profitable due to increased consumer spending as a result of lower borrowing costs.

Strong portfolio of companies

The MCHI ETF manages $5.9 billion of assets and boasts a very decent portfolio of 632 high-quality Chinese companies, many of which are at very attractive valuations themselves. While I won’t be diving deep into each and every one of them, let’s go over the two companies that hold the highest weightage in this portfolio.

Tencent Holdings Ltd

Tencent Holdings Ltd (OTCPK:TCEHY) (0700.HK) currently makes up about 13% of MCHI’s portfolio. The company itself is one of China’s biggest technology companies, and it is currently at a pretty attractive valuation in the H.K. stock market. This is due to not only the fear of investing in Chinese equities, but also a huge drop in the Hang Seng Index as a result of the Russia-Ukraine crisis.

Tencent’s financials

Based on past year financials, Tencent Holdings has had extremely healthy revenue growth, from $177.53 billion in 2016 to $541.69 billion in 2020. This is an overall 205% growth in revenue from 2016 to 2020. Over the same period, EPS (earnings per share) has also increased from 5.06 to 18.57, which is a net growth of 267%. Lastly, free cash flow has increased from $69.59 billion to $180.62 billion over the same period, representing a net growth of 160%.

Tencent’s current valuation

Despite these impressive financials, the company trades at about 384 HKD a share in the H.K. stock market, which is about a 45% drop from its 52-week high of 694.5 HKD. It’s important to note that the company is arguably in an even better financial position now, compared to the time when it was trading at 694.5 HKD, yet we’ve seen the price drop by almost half. This represents great upside potential, which translates to decent growth prospects for MCHI ETF.

Alibaba Group Holding Ltd

Alibaba Group Holding Ltd (9988.HK) currently makes up about 8.7% of MCHI’s portfolio. This company is another tech giant in China, with its main focus on retail and e-commerce.

Alibaba’s financials

The company’s revenue has grown from just $182.51 billion in 2017 to a massive $820.2 billion in 2021, representing a startling 349% net increase. Over the same period, EPS has also grown from 2.45 to 7.82, representing a 219% net increase. Finally, free cash flow has increased massively, from $72.39 billion to $215.66 billion over the same period, representing a net growth of 198% over the same period.

Alibaba’s current valuation

Just like Tencent Holdings, the price of Alibaba Group Holding’s shares in the H.K. market has tanked drastically. It currently trades at about 96 HKD a share, which is about a 60% drop from its 52-week high of 241.6 HKD. It is also noteworthy that the share price has reached its new all-time low of 92.6 HKD a few days ago, despite the company logging a double-digit growth almost every year. The company, like Tencent Holdings, has tremendous upside potential, and would move MCHI ETF in the right direction if this potential is realized.

Valuation compared to its S&P500 counterpart

MCHI ETF currently has a portfolio P/E of 12.88. In comparison, its S&P 500 counterpart (IVV) trades at a portfolio P/E of 20.64. Do take note that this is not a sign that MCHI ETF is a better buy than its S&P 500 counterpart, neither does it confirm that it is a better value play. It does, however, provide some kind of reference to show that the MCHI ETF is at a relatively low valuation as a result of the massive sell-off. It may represent a great opportunity to either average down on your position or start a position at a decently low price.

Risks

While the upside potential is very promising, there are some risks regarding MCHI ETF that need to be addressed.

Regulatory concerns

Over the years, there has been a lot of uncertainty with regard to regulatory concerns that may negatively impact Chinese companies. Just last year, we’ve seen many regulatory risks concerning delisting and/or privacy laws that have brought the share price of companies like Alibaba Group (BABA), FUTU Holdings (FUTU) and UP Fintech Holding (TIGR) to their knees. The ban of for-profit tutoring has also seen companies like TAL Education Group (TAL) and Gaotu Techedu (GOTU) crumble completely. It’s no surprise that many investors, especially those who are risk-averse, have fled from Chinese equities during this brutal regulatory crackdown. While we may be seeing some amount of regulatory easing with regard to Chinese companies in more recent times, this concern cannot be overlooked.

Disappointing historical return

MCHI ETF has a historical return of about 3%, which is pretty disappointing for an ETF, considering the SPDR S&P 500 ETF Trust (SPY) has managed to achieve a historical return of about 9%. This poor return is largely attributed to the huge fear surrounding Chinese equities, which has led to many events of panic-selling. An important thing to note is that historical returns aren’t always representative of the future, especially for Chinese equities which move more greatly on sentiment as opposed to fundamentals. Nonetheless, the metric falls short of other ETFs.

Relatively high expense ratio

MCHI ETF has an expense ratio of 0.57% This is slightly higher than the expense ratio of the average equity ETF, which stands at about 0.5%. While MCHI ETF has a low expense ratio compared to a mutual fund, it is definitely on the pricier side when compared to other equity ETFs in the market. However, it is good to note that MCHI ETF’s expense ratio is relatively lower as compared to other Chinese ETFs like CHIX and KBA.

Investment decision

All things considered, I would give this ETF a moderate ‘Buy’ rating based on the bull case where the companies in its portfolio, like Alibaba and Tencent, soar back to their fair valuations once there is renewed confidence in Chinese equities. We’re already seeing signs of this, and if Chinese equities do indeed see a strong recovery, it is no question that MCHI ETF will rise accordingly in valuation. As of today’s valuation, MCHI ETF has good upside potential, since a large proportion of companies in its portfolio are undervalued, with many unrealized fears already priced in. If it fits your risk tolerance, this is a good investment opportunity.

Conclusion

In conclusion, I believe that investing in MCHI ETF is a calculated risk. However, I am convinced that the upside is greater than the downside at the current valuation, especially when considering the fundamentals and upside potential of the companies in the ETF’s portfolio. While the risk is undeniable, this could be a great way to gain exposure to Chinese equities if it suits your risk appetite. I’ll be putting this one on my radar and issuing a moderate ‘Buy’ rating for MCHI ETF.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.