Preamble
From, what we recognized then, an unsustainably high valuation level of over 30x earnings in October 2007 China stocks have been in a multi-year valuation bear-market. Following the recovery from immediate post GFC lows valuations made a lower high in July 2009 of around 20x before heading down again. In August 2011 they dropped below 10x where they’ve stayed ever since. Presently, the market in aggregate [Throughout ‘market’ refers to the Hang Seng China Enterprises Index or HSCEI] is trading on just slightly north of 6.5x e2015 earnings; an unprecedented low in my career.
So, to address the title, do we now accept this state of affairs as China’s new normal? Or, is this extreme cheapness a parenthesis from which a recovery to more rational valuation levels eventually takes place?
Summary Conclusion
The idea that a market deserves a permanent valuation discount is often associated (in this part of the world at least) with Korea. I’m not familiar enough with the specifics of the Korean market to do a compare and contrast with China but what I’ll argue below is, taking a closer look at fundamentals, the application of a China-discount to Chinese stock valuations isn’t consistent with the reality of their circumstances.
I conclude therefore we are indeed in a valuation parenthesis; from which, in time, we’ll emerge.
Let’s look in more detail why permanent valuation impairment is unlikely.
1) A Permanent Valuation Impairment is Unlikely Because? Earnings Growth Has Been, and Remains, Persistent
These are the earnings growth numbers for the market for the last four years and consensus forecasts for this year and next; 2010 +31%, 2011 +12%, 2012 +4%, 2013 +14%, e2014 +8% and e2015 +8%. For the six year period that’s a total of just over 100% or a CAGR of nearly 13%. The sniffy will note much of this is from the finance sector; so? Investors have been paid very real dividends and benefited from the equally real uplift to book values that’s taken place. Besides, if growth were entirely confined to the finance sector I’d accept push back, but it hasn’t been.
Property companies (despite gloomy prophesy in 2010) have grown their businesses strongly over the period. The consumer has maintained an open wallet policy that’s fed through to all manner of other companies and, yes, top line growth has come down some but the government is still blessed with economic growth the envy of the world. Not only have earnings not collapsed in recent years, they’ve grown; and strongly. So this can’t be a factor that would permanently affect valuations?
2) A Permanent Valuation Impairment is Unlikely Because? Yields, in a No-Yield World, are Compelling
Many state-owned listed Chinese companies are tips of bigger cash hungry groups and private sector companies have either a tight family shareholding structure or a single individual to whom the bulk of economic benefits flow. In regards to how this shapes dividend policies it should be clear this is likely to encourage generosity. China’s largest telephony operator yields over 3%, state owned banks yield more than 5% and private sector property companies have, in some cases, double digit yields. Here, for example, are the top three yielding H-shares (in their respective industry groups) with market capitalizations in excess of U$2bn: CCB 6.7%, China Shenhua 5.5%, Huaneng Power 5.2%; not exactly a fly-by-night bunch?
I don’t know that Korean companies have ever come close to these sorts of yields? I suspect they’ve been and remain a long way short? The persistent and rising generosity of payouts (Bank of China, the first big state owned bank to privatize, has raised dividends every year since listing) from Chinese companies can’t then be a hindrance to valuation; in fact, it can only drag valuations up over time.
3) A Permanent Valuation Impairment is Unlikely Because? China is Just Too Darn Big To Be Ignored
For more than 20-years Japan has fumbled but over that period the percentage of the market owned by foreigners has gone up. Different folk have different takes on this. Some say despite headlines there are good companies worth sticking with, others finger the tyranny of indexation. I think it simply boils down to size. The Japanese stock market is simply too big to ignore. Korea, and most of Asia ex-China, is a rounding error that can be avoided and outside of one or two of its biggest companies, I’m told, liquidity in Korea fades fast so even if you wanted to make it a big part of a global portfolio it’d be hard.
Even after the multi-year frustration investors have had with Japan there’s never been talk of a Japan discount; in fact, despite the problems of low payouts, poor governance and insouciant shareholder communication Japan, if anything, maintains a curios premium which only it’s relative size can explain.
Whether it’s the Hong Kong – Shanghai stock connect or the ease now with which professional investors can obtain QFII quota or greater capital account flexibility the trend in terms of China access for non-Chinese investors is a one way street; and greater liquidity is rarely associated with persistent undervaluation. Especially when the underlying economy is likely to become the world’s biggest in the not too distant future.
4) A Permanent Valuation Impairment is Unlikely Because? Future Prospects Remain Unequivocally Bright
I hold this truth particularly self-evident. I’ve been visiting China for 27-years and have never been on a visit, never, no matter how near or far from a previous one, where something hasn’t gotten better. Sure, some things like the environment (may) have gotten worse; but that’s a growth quid pro quo that no country in the history of all newly industrializing economies hasn’t had to accept. Moreover, China is moving faster to correct the problem than many economies at a similar stage of development ever did. On the other side of the ledger new roads, rail networks, aviation infrastructure, homes and rising standards of living will go on paying dividends long after the Beijing smog has cleared.
I don’t know that we’re heading into a Chinese Century, but I do know the gains China has achieved are not illusory. The economy is not a Potemkin village where papier mache buildings sway in the breeze. It’s real, it’s not going away and it’s going to go on going on. This is clear. Hard then to see why assets located there should remain significantly undervalued relative to those globally comparable?
A Permanent Valuation Impairment Could Have Taken Place
China does have big problems. I’ve often imagined policy makers being confronted with something like a multidimensional game of Whack-A-Mole; and this won’t change. We seem no longer to be in fear of the imminent financial Armageddon that shadow banking or LGFV problems were sure to trigger. Today we’re now vexed about the effects of the anti-extravagance/corruption campaign. Or is too much power being vested in one man? Is there a civil war underway in the CCP? Can the transition to more sustainable growth [BTW, what is that? Ed.] be accomplished smoothly [No. Ed.]? And so on.
In addition, in the last few years China has had its fair share of corporate governance issues. NASDAQ and Singapore listed China stocks (I refer only to the shabbier i.e. most) probably have been correctly re-priced, and with good reason. A-shares are being shunned by domestic investors who are learning a long and painful lesson about the importance of fundamental analysis and global investors have had much more fun in many of their home markets in recent years. It may be that emerging markets, for which China is the poster-child, have been sent to a dog-house from which they never emerge? I won’t rule this out.
..But So What?
Consider two scenarios.
The first is there has been a permanent valuation impairment in Chinese stocks and a China-discount is going to be applied from now to eternity. You buy, collect your dividends, maybe get a little bit of capital appreciation to reflect higher earnings; there are worse things.
The second is present valuations are a parenthesis from which we emerge. You buy, collect your dividends, maybe get a little bit of capital appreciation to reflect higher earnings AND you benefit from the rerating that, even if it goes only to the bottom end of developed market norms, would be a very nice thing indeed.
In Conclusion
Chinese stock valuations present investors currently with a heads-you-win-tails-you-don’t-lose proposition. What will precipitate change to the current situation? I have no clue; the word catalyst, like crisis, can only be properly applied to situations in retrospect.
What I do know though is cheap is less persistent than dear in the world of investing; and Chinese stocks are unarguably cheap today. When, and how, they emerge from this parenthetical state is anybody’s guess; but emerge they will and I want to make sure I’m involved when this happens.
Sure, it could be a while yet; but investors know one of the most dangerous assumptions they can make is for present trends continue; because they rarely do.