Last week, I talked about how emerging market investors are increasingly leaving Chinese stocks out in the cold. If you’re a China bull, you may argue that including Chinese stocks as part of a wider “emerging market” category isn’t fair to those skewing further left on an emerging/developed market spectrum. And that’s a fair point. As I said in that article, China’s 30% share of the overall emerging market sphere reduces the impact of smaller-cap companies in, for example, Brazil, in favor of a heavier Chinese stock concentration that’s better off categorized separately.
But that’s the bull thesis.
An alternate and no less justified tact says that overexposure to Chinese stocks puts investor capital at risk in a market with an over-engineered economy that can (and does) step into private companies’ business as the government sees fit to serve collective Chinese interests at the expense of shareholders and stakeholders.
That’s how one analyst describes the recent decision to cut 66 Chinese stocks from major global indices, saying, “It highlights the issue of negative flows for Chinese stocks as investors reduce exposure to the country, in large part due to recent weak fundamentals, but also fears of ongoing financial instability, regulatory uncertainty, and — most of all — country risk.”
These three Chinese stocks to avoid tend to be popular among retail investors — but HODL at your own risk.
Alibaba Group Holding (BABA)
Even from a bullish Chinese stock perspective, Alibaba Group Holding (NYSE:BABA) is worth trimming or cutting out of your portfolio completely. Not purely because of the geopolitical and economic risks, but because direct competitor Pinduoduo (NASDAQ:PDD) is increasingly edging out and putting pressure on the e-commerce retailer.
Though it remains slightly smaller than BABA based on market cap, PDD shares far outperformed Alibaba, returning 60% over the past six months compared to BABA’s 25% loss over the same period. But the biggest risk facing BABA, as it relates to losing its once-top spot to Pinduoduo, is discount pricing and market share. Right now, PDD is beating BABA on both counts.
But BABA isn’t helping itself either, considering it missed recent earnings estimates. Though buybacks and dividends might boost the stock’s price in the short run, its long-term prospects are less clear. The company is, á la Amazon (NASDAQ:AMZN), increasingly pivoting outside of its e-commerce purview, notably within cloud computing. But that market is increasingly flooded, and, with less than 10% of the global market, BABA’s peripheral ambitions risk eating into slim margins and bringing the Chinese stock down further.
Nio Inc (NIO)
From a macro perspective, electric vehicle (EV) manufacturer Nio Inc (NYSE:NIO) faces risk as the global EV market cools amid regulatory churn and reduced overall demand. And, like BABA, NIO faces substantial pressure among comparable Chinese stocks and stiff international competition. For example, of the overall Chinese EV market, Nio claims just 2% of the overall market share, leagues behind BYD’s (OTCMKTS:BYDDF) 35% market share and Tesla’s (NASDAQ:TSLA) 8%.
As InvestorPlace’s Louis Navallier covered recently, even aggressive government stimulus isn’t enough to save the Chinese stock. His research note pointed to the company’s plummeting monthly vehicle delivery rate alongside consistent unprofitability. That fundamental weakness isn’t enough for government stimulus and short-selling restrictions to overcome. Though the stock bounced on the overall news, don’t expect the rebound to last. The company is still overvalued by any practical metric, considering it trades at 1.2x sales and more than 4x book value today.
Chinese EV stocks are a risky proposition overall, considering global expansion concerns, tariffs, and supply chain problems relating to high-tech components that next-gen cars demand. If you must pick one, stick with Charlie Munger’s recommendation — but avoid Nio at all costs.
iShares MSCI China ETF (MCHI)
Expense Ratio: 0.59%, or $59 annually on a $10,000 investment
Of course, if you want to avoid (or short) Chinese stocks based on their fundamentally skewed risk/reward profile, iShares MSCI China ETF (NASDAQ:MCHI) is the clear “winner.” The basket of Chinese stocks holds many publicly tradable on U.S. exchanges but, critically, also a handful inaccessible through domestic investment platforms.
For example, though BABA and PDD are both top MCHI holdings, the ETF also has Chinese stocks like China Construction Bank and Ping Insurance. With more than 15% of its overall weight attributable to financial stocks like these, MCHI’s per-share price faces massive downside risk if the Chinese government can’t contain rapid economic decline.
MCHI’s short interest has remained fairly steady, though elevated, over the past few months. If you’re interested in keeping a close eye on Chinese stocks, this ETF is the easy pick to monitor overall investor sentiment in the region — and whether smart money sees Chinese stocks heading for a cliff.
On the date of publication, Jeremy Flint held no positions in the securities mentioned. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.