Residential towers in China
It’s going to take more than the world’s deepest stock-market selloff to turn China into a destination for international bargain hunters.
Even after a 40 percent tumble in the Shanghai Composite Index over the past 12 months, valuations for China’s domestic A shares are three times as expensive as every other major market worldwide. The median price-to-earnings ratio on the nation’s exchanges is 59, higher than that of U.S. technology shares at the height of the dot-com boom in 2000.
One year after China’s equity bubble peaked, valuations have yet to fall back to earth as government intervention keeps stock prices elevated at a time of shrinking corporate profits. For money managers at Silvercrest Asset Management and Blackfriars Asset Management who predicted last year’s selloff, China’s weak economic growth and fragile investor sentiment mean it’s too early to jump back into the USD6 trillion market.
“We do not own any A shares,” said Tony Hann, the London-based head of equities at Blackfriars, which oversees about $270 million. The firm’s Oriental Focus Fund has outperformed 83 percent of peers this year. “The bull case seems to be that I can buy at this P/E because someone else will buy it from me at a higher P/E. The biggest risk is that investor psychology on the mainland changes.”
There’s plenty for investors to be worried about. After expanding at the weakest pace since 1990 last year, China’s economy shows few signs of recovery. Earnings at Shanghai Composite companies have declined by 13 percent since last June, while corporate defaults are spreading and the yuan is trading near a five-year low.
The gloomy outlook is a stark contrast to the mood this time last year, said Pan Lizhi, a 54-year-old retiree in China’s Hunan province.
Like many of the country’s 106 million individual investors, Pan traded shares almost every day during the bubble, hoping to ride a boom fueled by explosive growth in margin debt and the official endorsement of state-run media. Now, she spends most of her time watching TV. Of the 320,000 yuan ($48,860) in her brokerage account, all but 6 percent is parked in cash. “I don’t foresee a bull market in the coming year,” Pan said.
Brokerage analysts are more upbeat. They still see gains for Shanghai Composite companies, with share-price targets compiled by Bloomberg signaling a 13 percent rally over the next 12 months. Potential catalysts for gains include this month’s MSCI Inc. decision on whether to include mainland shares in its international indexes and the anticipated start of an exchange link between Hong Kong and Shenzhen.
Bulls say the downside for share prices is limited by government intervention. China Securities Finance Corp., the agency armed with more than $480 billion to prop up the market last summer, still owns at least $77 billion of mainland equities, according to exchange filings compiled by Bloomberg. The true scale of government support is almost certainly even bigger, with cash from CSF and other state funds flowing into the market through multiple channels that don’t always show up in public disclosures.
Not everyone is concerned about China’s valuations. While the market’s median price-to-earnings ratio is an appealing metric to some analysts because it downplays the impact of low-priced bank stocks with big index weightings, others prefer an aggregate measure that gives more influence to the largest companies. On that basis, the Shanghai Composite trades at 16 times reported earnings, cheaper than the S&P 500’s multiple of 19.
“China’s actually quite attractive,” said Sam Polyak, a Boston-based money manager at Fidelity Management & Research Co., whose $71 million Fidelity Total Emerging Markets fund invests in A shares through the Shanghai-Hong Kong exchange link. He prefers Internet and consumer staples companies, along with select industrial firms.
Finding bargains in China is difficult because shares with depressed valuations often have problems, while firms with the best prospects are pricey, according to Daniel Morris, a senior investment strategist in London at BNP Paribas Investment Partners, which oversees $592 billion.
On the low end, Industrial & Commercial Bank of China Ltd. trades at 5.6 times reported earnings. The nation’s largest lender has dropped 16 percent over the past year amid concern that a surge in non-performing loans will erode profitability. Leshi Internet Information & Technology Corp., which boosted revenue by more than 90 percent in 2015 and was one of the darlings of last year’s bubble, has a multiple of 175.
“Some parts of the market are cheap, but perhaps for a good reason,” Morris said. “The parts that you like, with the growth potential, you’re paying for that.”
China’s dual-listed stocks offer perhaps the clearest indicator of the persistent disconnect between valuations on domestic exchanges and those in international markets. Mainland shares fetch an average premium of 93 percent over identical equities traded across the border in Hong Kong, with the gap reaching as high as 634 percent for Luoyang Glass Co., a producer from Henan province.
“There’s a lot of downside to China’s market,” said Patrick Chovanec, the chief strategist at Silvercrest Asset Management, which oversees about $17 billion in New York. “The fundamentals are poor and perhaps getting worse.” Kyoungwha Kim and Bonnie Cao, Bloomberg
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