A copycat economy built on credit overly reliant on exports. Appalling corporate governance, unhelpful IR teams and hardly cheap stocks. Sound familiar? I’m not referring to China stocks today though. This was the received wisdom about Japanese stocks when I began my career in Asia in Japan in 1984; and we all know what happened next?
Summary Conclusion
In some respects, China’s stock markets resemble those of Japan in the early 1980’s. Then foreign investors ignored Japan as being too much trouble to merit more than a few token bets. Now, China’s stock markets are the second largest group of listed companies in the world but make up far less than that as weighting in institutional investor’s portfolios.
Should these investors feel the need to just neutral-weight China an ‘80s style Japan-like feeding frenzy would ensue as such a move would most likely be triggered, as it was in Japan, by domestic investors also increasing weightings. Upward pressure on stock prices would be intense and would most likely be a multi-year phenomenon.
What makes this possibility especially interesting is China stocks today are cheap. Investors therefore have a more favorable risk profile than they faced in Japan in the 1980s.
Perhaps nothing happens from current levels? Or, perhaps we do (a bit of?) a Japan? Put another way that’s a 50% chance of a zero return (100% chance of a zero return if you stay in cash) followed by a 50% chance of a significant upward price correction. Nothing in markets is ever a certainty but these are, IMHO, attractive odds.
Japan Then – China Now
There are five characteristics of the China markets today that have parallels in pre-takeoff Japan.
1) Corralled domestic savers. Mom and Pop savers in Japan didn’t have a lot of choice about how to invest back then and they were all (mostly) becoming better off. China has exactly the same dynamic today. The regular bubbles in everything from garlic to forward steel prices remind that far from a debt problem China has a much more underappreciated problem; savings. China won’t relax capital controls sufficiently in the next few years to bleed this problem from the system and idle funds will find their way into the stock market again and, just as in Japan, the pool of frustrated savings is only getting bigger.
2) All the big listings are done. The flotation of NTT in 1987 (there was a first tranche in November 1986) was a big deal because it was, well, a big deal. At the time the deal was worth U$38bn. Stock was initially only available domestically and foreigners scratched their heads at the valuation. Apocryphal Mrs. Watanabes figuratively formed queues around the block; but the enthusiasm for the sale had as much to do with rarity of new large listing as the intrinsic value of the company. Today, with the exception of the State Grid China, has also already listed its largest enterprises.
3) Free float is smaller than you think. In Japan foreigners quickly learned that so-called free floats were nothing of the sort. Beneath the large blocks held and declared in the major corporations there was a raft of friends, families, suppliers, customers, affiliate banks and so on that held stock that wasn’t for sale under any circumstances. The problem isn’t perhaps as acute in China but of the top ten stocks listed in Shanghai today nine of them are controlled by significant direct government stakes. These are also probably not for sale, at least for the time being, at any price.
4) The flip to self-sustaining internal economic growth has been made. One of the reasons foreigners were so keen on Japan in the 1980’s was the realization the economy was no longer just an export powerhouse. It had developed its own momentum based on a pattern of robust domestic consumption. The Chinese economy has similarly inflected. The service economy is a bigger component of GDP now than the manufacturing sector; and its share of the total is growing. Domestic brands are gaining momentum and progress since the GFC underscores the point that the domestic economy now has a life of its own.
5) International investors are (extremely?) underweight. The parallel is striking with Japan then and China now. Reliable numbers are hard to come by but China has been in the institutional investors’ dog-house for so many years the structural underweight is likely substantial. If the China markets begin a sustained rally this underweight will be agonizing. First it’ll get worse if investors don’t respond quickly (they never do). Then it’ll be hard to get to just at-weight let alone the overweight position institutional investors’ clients will expect in light of the then price action.
China Now – Better Odds
China differs today from Japan in the 1980s in one very important respect. Many of its listed stocks are cheap.
For most non-Chinese investors the easiest place to invest is among the listed China shares in Hong Kong. Here they’ll find banks at percentages of book values with sustainable high single digit yields. They’ll find property companies trading at fractions of the value of bought and paid for land banks and large manufacturing and industrial enterprises trading far from asset replacement cost.
The valuations of Chinese stocks could go lower; and there are parts of the market where bubbles are visible, but these are outliers. Mainstream China Inc. is priced lower than comparable assets elsewhere in the world; and this favorably tilts the risk-playing-field. How so?
China stocks offer not a single bet but two, one after the other. The first bet, with a 50:50 chance outcome, is of either losing nothing or making something. The second, another 50:50 chance outcome, is of making either a modest or a large return. The package combined produces a 75% chance of some sort of return.
In Conclusion
There are of course many differences between the totality of China today and the Japan of the 1980s. However, in the following respects there are parallels.
Japan then and China now had/have confined and increasingly affluent domestic savers. There’s an absence of large new equity supply combined with de facto low free-floats for existing listings. Japan transitioned and China is transitioning into a domestic economy capable of self-supporting internal growth and finally, back then, Japan was a severe underweight for most global investors, as China is today.
A significant difference however between the Japan of the past and the China of the present is the low valuations of many China stocks that make involvement in its stock markets a much less risky proposition than investors faced in Japan in the 1980s.
Heads you win; tales you don’t lose. Works for me.