Chinese Stocks Look Cheap. But Bargain Hunters Risk Losing Big.

China has a billion people, one fellow explained. Its economy is small, but it’s embracing capitalism and freedom, so it’s bound to soar. Investing there now is like getting in early on U.S. shares.

It sounded plausible. A year before the fund launched, a man named Boris Yeltsin had climbed onto a tank in Moscow to defy a Communist hard-liner coup, and just like that, the Soviet Union was gone. Barely a decade before that, I had done drills in school to prepare for a Soviet nuclear strike. The world was changing quickly.

To its credit,

Eaton Vance Greater China Growth
(ticker: EVCGX) has returned nearly 5% a year since inception, while the broad Chinese market has made next to nothing. But the U.S. market has returned 10% a year.

What went wrong? Not growth. China’s economy soared, just like the wholesaler said, even without capitalism. But studies over the years have blown holes in the assumption that gross domestic product and stock returns are closely linked. One reason is that economic gains are often driven by new firms that haven’t yet made their way into shareholder hands. Another is that shares in high-growth economies are sometimes too expensive.

Today, U.S. investors have their pick of world-class Chinese companies that trade on U.S. exchanges, and a two-year rout has left many of them looking cheap.

Alibaba Group Holding

(BABA), a data-driven colossus in retail, logistics, lending, and more, has generated $89 billion in free cash over the past five years, versus $75 billion for

Amazon.com

(AMZN). Its shares are lower than their debut price in 2014.

Alibaba’s market value of $168 billion is now a sliver of Amazon’s $1 trillion. Search giant

Baidu

(BIDU) goes for 11 times earnings, and videogame maker

NetEase

(NTES), 13 times. The selloff this past week was “disconnected from fundamentals” and “presents an opportunity,” argue strategists at J.P. Morgan in a note.

But I’m wondering whether China has become uninvestible. Or more specifically, is the best allocation for U.S. investors zero, indefinitely?

I laid out the bear case this past week (“Chinese Stocks Are a Screaming Bargain. Don’t Buy Them.”). American depositary receipts don’t give U.S. investors ownership rights in China, and economic relations between the two countries are increasingly thorny. Xi Jinping, the most powerful Chinese leader since Mao, sparked the latest selloff by replacing market-friendly technical experts in his leadership group with yes men. What’s to stop Xi from taking aggressive action against U.S. investors or the companies that have raised money from them?

China ADRs, after all, are based on an irreconcilable hypocrisy. Companies raise money in two main ways: borrowing (bonds) and selling part ownership (stocks). China bans foreign ownership in broad swaths of its economy. But its companies want U.S. cash and trading liquidity. And U.S. investors, during a decade of near-zero interest rates, were up for just about anything. So, Chinese companies created offshore “variable interest entities,” or VIEs, with rights to a cut of their income, and sold ownership in these.

U.S. regulators don’t love the arrangement because Chinese companies have spotty financial reporting. That’s by design; China views many accounting details as state secrets. U.S. lawmakers have told these companies to comply or delist, and China says it will provide more financial information, but there’s also a three-year period that companies can use to set up secondary listings, and some have done just that in Hong Kong. These H shares, as they’re called, also offer VIE exposure rather than true ownership.

Now, I’d like to give the bull case a fair hearing. It comes from Jason Hsu, a renowned market researcher turned money manager, first in the U.S. and now in China, through Rayliant Asset Management.

“The pendulum always swings to the extreme,” says Hsu of fears that U.S. stock investment in China is built on shaky ground. “I think there’s too pessimistic an assumption as to the Chinese authorities’ interest in essentially blowing that up and wiping out global investors.” One of Xi’s goals is to make China’s renminbi a global currency and competitor to the U.S. dollar, says Hsu. Weaponizing renminbi-based assets would undermine that goal. “He wouldn’t do that,” he says.

Hsu says that investors who have the option of selling China ADRs and buying comparable Hong Kong shares should do so, and capture any tax loss. Alibaba has applied to convert its secondary Hong Kong shares into primary shares at the end of this year, which would make it eligible for the Stock Connect program that links trading in Hong Kong and mainland China. Hsu expects more of that, with some companies fully repatriating their listings by issuing mainland shares while buying Hong Kong ones. “That problem will be solved,” he says. “It will not be solved in a way that is just outright robbing existing shareholders.”

Meanwhile, UBS points out that Chinese shares are the cheapest in a decade, and that positive policy surprises could create a sharp rally, but that it’s waiting for more certainty. It recommends that investors stick with a 3% stock weighting in China, equal to its share of the world’s stock markets. And I’m still unclear on why long-term savers need even the 3%. U.S. tech giants are slumping. But so is Alibaba, which has announced layoffs amid declines in revenue and profits.

The new case for China seems to be that capitalism and freedom are out of the question, but that shares are pricing in the potential for confiscation, and that won’t happen, either. I prefer the pitch from 30 years ago, when at least it came with a sandwich.

Write to Jack Hough at [email protected]. Follow him on Twitter and subscribe to his Barron’s Streetwise podcast.