China; fizzy stock markets, prosaic reality. What’s going on?

The reality of events in China in the first quarter was that not much happened. The results season was a ‘meh’, underlying trends in the broad economy remained mixed and the anti-corruption campaign continued to affect decision making contributing to the new normal pace (slower) of economic development. So what’s with these fizzy stock markets?

I’ll try and answer that question at the end of this note. Before that though let me digress for a closer look at corporate profits and the bigger picture.

2014 earnings – Meh

One new belt, one normal road. I didn’t read a 2014 annual report that didn’t cite either the One Belt One Road (OBOR) plan or New Normal; the latter in all cases being a euphemism for slower. These phrases can be interpreted in many ways but together they sum up the plan for future economic development; and what’s important is there is now a plan.

New normal is a way of expressing the old compact the Chinese Communist Party had with the citizenry has been revised. In the past it was about delivering a quantity of things. In future the Party’s legitimacy will rest on its ability to deliver a quality of things. This shift was inevitable once a sufficient number had been pulled out of poverty. All over the world the poor aspire to three squares, the less-poor aspire to clean water and air. The good news for the Chinese population is the Party is on top of this. The bad, for investors at least, is some business models won’t work so well in future.

One Belt One Road looks like old wine in a new bottle; it isn’t. Superficially it appears to be a throwback to the if-you-build-it-they-will-come policies that have transformed much of China in the last 30-years. In part it is but it’s so much more about spreading China’s development model (highly effective if you’ve just missed the last three decades) to the neighbors. Not only is the plan to create a greater China co-prosperity sphere it’s also about influencing the way half the world develops over the next 30-years. The details are necessarily still a work in progress but cynics should be reminded that’s the nature of all economic policy.

To the numbers specifically. Not many had a rollicking 2014 but because Chinese company managers communicate more reliably than in the past there weren’t many surprises. In aggregate though corporate earnings rose making this the sixth straight year this has been the case. Most managements were cautious in their outlook for 2015 but the big receivables blow out in the last few years appears to be coming to heel. Leverage seems contained and with little or no inflation even modest earnings gains represent real progress. The impact of lower commodity and energy prices was only visible via the lower earnings of producers and what must be a huge dividend for China Inc. seems not to have arrived, at least not yet.

China Inc. 

Turning to the broader picture; Q1 China has been a hard place to say much good about. The economy is being retarded, the property market is showing signs of stress on the periphery, the anti-corruption campaign shows no sign of let up, deflation may soon be a concern and bad debts are rising. Not the sort of background expected to inspire much confidence and fund flow data suggests foreigners in particular have only been reluctantly committing.

Sure, the government has taken its foot off the property market’s wind-pipe. Yes, we had some cuts to interest rates; but China is still running a very tight monetary policy and yes, the government have promised stimulation where necessary; but little if anything has been forthcoming to date.

The first quarter also reminded investors how much investing in China is a through-a-glass-darkly process with the brutal pulverizing of a publicly listed company for reasons we are presently left only to surmise. I’m referring to Kaisa 1638. Since December the stock has been suspended on six occasions (and is so presently). Senior management resigned en-masse in late December and what looked like a plausible rescue attempt appears to have been scuttled. We’ve seen Chairman locked up for loosely  specified crimes before in China, it sort of goes with the territory; but I don’t believe we’ve ever seen anything as destructive as what’s been done to Kaisa? Of a number of disturbing things (from an investor standpoint) about this event is its proximity to Hong Kong which, you would think, would make reliable information easier to track down? I’ve written in the past about how China stocks don’t deserve a China-discount but one or two more Kaisas and I’d need to revisit that view.

If the bottom up Q1 summary then is a meh, the top down equivalent might be ehhh?

Those Fizzy Stock Markets

The Shanghai Composite index rose by 17% in Q1, the Hang Seng Index rose by a less impressive 8.5% and the Hang Seng China Enterprises Index advanced an almost curmudgeonly 7%. There’s clearly a divide between domestic investors’ views of the right price for China assets and those of investors farther away. So who’s right? As I don’t think markets are run by fools I believe both are; the only difference being time periods these two groups are framing their investment decisions within.

A stock price decomposes broadly into two factors. One is the embedded value plus future earnings prospects. The other, which nobody has ever managed to reliably model, is the right price to pay for the package. This second variable to some is the price to book, for others it might be EV/EBITDA; for me P/E (in most cases) does fairly reliable heavy-lifting.

It’s hard to see why investors, domestic or foreign, would be anticipating a forward earnings surge? What must be happening then is domestic investors have increased the time frame in which they’re expecting earnings to be persistent. As a result the amount, all things being equal, they’re willing to pay for assets has risen.

Overseas investors may have done the same calculation on earnings and intrinsic value as domestic investors but must be less optimistic about their persistency? So far so rational; what we haven’t considered though is why domestic investors are more confident than those overseas?

The X-Factor

According to work published in December last year by the Ash Center for Democratic Governance and Innovation at the Harvard Kennedy School Mr. Xi Jinping had a 94.8% approval rating among Chinese citizens (the highest ranking by a domestic population of their leader in the world). In addition he topped the poll where international voters were asked to rate other country’s leaders. At home and abroad he’s clearly a force; but only at home is his administration really getting into its stride.

The anti-corruption campaign may be a purge in all but name but there’s no doubt it’s very popular. There’s also no doubt it’s much more than lip-service to the problem previous administrations were guilty of.  Last year a total of 232, 000 government officials were ‘disciplined’, a 30% increase on 2013. What’s getting less attention is how the public are participating in this process. In 2013 1.95m whistleblowing letters were received by authorities, in 2014 it’d gone up to 2.7m; a 40% increase. People-power indeed.

Mr. Xi fumbled early on with his China (or Chinese) Dream advertising an aspirational destination without being able to give directions. This looked much like the same form over substance megaphone exhortations that Chinese have learned to tune out. However, signs with clear directions to the China Dream, are now appearing. One Belt One Road (see my last Sunday paper for more) is much more than a concrete pouring, track laying nice idea; it may, for China, be a global game changer. Imagine a continent stretching from Lisbon to Qingdao fully economically integrated. Imagine a world where American naval hegemony ceases to matter. Imagine a fresh new crop of developing economies. Imagine now, at the center of all that, China. Pretty dreamy if you ask me?

New normal is also more than an excuse for company managers to explain slower earnings growth. It reflects a sea change in philosophy which the population gets and approves of. High speed trains or clean air used to be the deal. New Normal permits the question, why not both?

In Conclusion

What’s underway in China is perceived by domestic investors as both good (anti-corruption) and inspirational (OBOR). More tolerated activism (those whistleblowing letters), a real dialogue on qualitative environmental improvement, a refocussed Chinese Communist Party and a grand plan to take the country to the next level of economic development. All of this is the reality of domestic investors’ lives and it’s no wonder they’re inclined to think China Inc., and the stocks that represent its proxy, are more valuable than before?

Overseas investors have been let down too often to want to quickly pay fancy prices for future prospects. Moreover domestic investors are still overwhelmingly retail operators where more heart than head drives investment decisions. If domestic optimism is, in time, justified though overseas investors may regret letting their more analytical institutional heads getting in the way. Looking into the future is always to gamble. However, just as it’s been said ‘It’s never paid to bet against America’ I’d say much the same about China; domestic investors are clearly of the same view.

That overseas investors are taking time to be persuaded suggests China’s stock markets can fizz along a while yet. Moreover, with valuations for many China shares listed outside China still in single digits overseas investors are still able to participate (as and when they so choose) at prices where future prospects remain very modestly priced.