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LONDON (Reuters) - Investors who have endured two decades of miserable stock market returns in China may have to wait a while yet for their bets to pay off as turbo-charged economic growth runs out of steam and a new economic model starts to evolve.
China has been the global economic success story of the past decade, booming at double-digit growth rates to establish itself as the world's second largest economy and hauling up a host of regional and commodity-rich economies in its wake.
Unsurprisingly, a lot of money has been staked on a belief that growing wealth in emerging markets and consumer demand for cars and computers will translate into handsome profits. Nowhere is that more true than China, to which funds tracked by Boston-based EPFR Global have channeled over $50 billion since 1995.
Yet given the scale of China's economic transformation and its indelible global impact, equity rewards have been abysmal.
A fund manager who invested in MSCI's China index at its launch in 1993, seeing 10 percent-plus annual GDP growth as a sure-fire guarantee of corporate profits and equity returns, would actually have lost 9.5 percent over that time, Thomson Reuters data shows.
Cash committed to stocks in the sluggish West would have returned almost 300 percent in the same period, while an investment in MSCI's emerging equity index would have increased four-fold in value.
The reverse has been true for bricks-and-mortar investment. Returns on foreign direct investment (FDI) into China are among the highest in the world, at more than 10 percent in every year since 2005, according to data from the United Nations.
Buying shares in U.S. firm Apple, which produces in China for export, was thus probably a better proxy for Chinese growth than local stocks.
China's runaway expansion induced investors to massively bid up share valuations despite an export-focused economic model that forced companies into manic expansion and paid little care to making profits for shareholders.
"Growth makes a great story but it doesn't deliver returns," sad Richard Cookson, global CIO of Citi Private Bank. "The big problem for China ... is that its growth model is dreadful."
Companies under pressure to grow have tended to fund themselves via vast equity issuance, which dilutes existing shareholders and hits growth in earnings-per-share (EPS), said Samy Chaar, investment strategist at Lombard Odier in Geneva.
The dilution effect in China can be gauged via the ratio of market capitalization to prices, according to Chaar, whose analysis shows dilution rates running at 11.5 percent by end-2009 - the highest among emerging markets and four times the rate in the West.
That means Chinese companies' earnings must grow over 11.5 percent a year just to keep EPS static.
"I don't know who has made money in China in the last few years," Chaar said. "People don't really get how dilutive the growth financing was and still is.
"The game changer will be a rebalancing of the economy towards a more domestic consumer-led model. That will come the day ... they come to a current account deficit."
That time may not be too far away. China's current account surplus has shriveled to under 4 percent of GDP from 10 percent in 2007.
Alarm in Beijing about the lopsided economy, over-reliant on global trade and with rising income disparities, has also led it to rethink the fast-growth model - aimed at rapid job creation via infrastructure investment and manufacturing for export - that lifted millions of Chinese out of poverty.
Most analysts expect it to eventually succeed in its objective to rebase the economy towards domestic demand and away from exports, reducing the need for breakneck expansion.
In an increasingly urbanized country with a billion-plus population, demand for goods and services will undoubtedly grow, although with investment still at 44 percent of China's GDP and social safety nets largely absent, that may take time.
Private consumption accounts for just one-third of Chinese GDP, while in fellow BRIC countries Brazil, Russia and India, the share is well over 50 percent.
"It's good for the longer term if growth becomes sustainable but I'm not sure it's immediately going to give you returns," says Maarten-Jan Bakkum, investment strategist for ING's emerging market funds.
Consumption has little scope to accelerate sharply in the near term, he argues, because the government is trying to reign in credit growth and dampen house prices. Chinese consumer demand stocks are relatively scarce and expensive as well, trading at double the valuation of their index peers.
There is also a more immediate fear: that the growth slowdown will gather momentum, leading to the dreaded hard landing. Many have grown more jittery since China ended the first quarter with the weakest growth in three years.
"At this point, going long China is a high-risk strategy," Bakkum said. "The market's longer term trend is negative and we think growth will slow more than many people think."
What has changed in China's favor is that share valuations are now relatively attractive. MSCI China is trading at a rare discount to emerging markets on a price-to-earnings basis and is under its own long-term average by around one-fifth.
That, and hopes of monetary easing, have pushed up shares 9 percent this year, on par with broader emerging markets stocks.
The improved valuations have drawn some $500 million this year into China funds, EPFR says, while Bank of America/Merrill Lynch's April poll showed fund managers overweight China for the sixth consecutive month.
"Historically China has been an underweight for us as we felt the valuations too rich ... and as such could not justify the price," said Emily Whiting of JPMorgan Asset Management.
"But China is now our largest overweight country position. The market has priced in too much bad news."
(This story corrected Lombard Odier location to Geneva from Zurich)
Graphics by Scott Barber; Editing by Catherine Evans