Sunday, June 14, 2015

Changing China and Its Stock Markets

In the last six weeks I visited Beijing and Taipei/Tainan for business and leisure.  I lived in Beijing in the mid-1990s and in Taipei for a summer in 1986.  I enjoy going to both places to see friends and business acquaintances and to broaden my horizons.  Hong Kong is dynamic, but not a great place to generate new ideas so it’s good to get out and hear different views, kick the tires and talk to people outside of my beloved Hong Kong.

Beijing. China is Changing

Beijing feels like it's comfortably moving into maturity.  Many of the hotels that were fashionable 30 years ago are looking a bit small and dated.  Even the ones that took their place are close to 20-years old.  On the street it’s no big thing to see high-performance German automobiles and the city's slow, crawling traffic reminds one of Los Angeles’ clogged freeways.   

Perhaps most tellingly, Beijing drivers mostly stay in their lanes - a sure sign that the cut-throat get-ahead attitude that characterizes an emerging market is transforming into a more livable, albeit a middle-staged economy with a slower growth. 

But it’s not just Beijing that's changed.  China’s economy is rapidly moving towards services.  It has been two years since the service sector overtook manufacturing as China’s primary growth driver.  It now accounts for 48% of economic output compared to 42% from manufacturing and construction (see article here).

Sometime in the last two years China’s upper middle class seems to have collectively decided that it’s okay to spend less time working and more time enjoying life. Friends are taking more vacations rather than only travelling for work.  WeChat postings chronicle trips around the world, pictures of very fancy and expensive dinners, and lounging around the pool and beautiful beaches. (For those who don't know, WeChat is like Facebook and WhatsApp mashed together on a mobile.)

In 1995 I was the only swimmer during a mid-summer visit to Yantai’s beach.  I was the only one in the water and the beach was mostly deserted except for a few curious onlookers. It now has a Sheraton resort and, if photographs are to be believed, can get quite crowded (picture here).

And it’s not just young people who are spending more money and time on themselves.  According to a recent article, Chinese seniors are going on holidays instead of just saving. The number of senior tourists jumped a whopping 58% in 2014 alone according to China Daily (article here).

Closer to the financial markets there are changing attitudes toward credit and borrowing.

Previously houses were bought with a large percentage of cash.  China's central bank requires commercial lenders to enforce a 30% down payment on standard mortgage loans. However P2P platforms offer prospective home buyers a way to fund this large down payment.  This is because they are not classified as financial institutions (article here).

And there seems to be more credit expansion on the way.

One example is a newly launched P2P lending platform called China Rapid Finance.  It made over 1.1m loans via its mobile platform between February and April this year and is targeting the 500m Chinese consumers untapped who have been tracked by China’s credit rating system, but have not borrowed any money.  Its advisers includes the co-founder of US lending power house Capital One (article here; website here).

Stock Market

Having doubled in the past six months, virtually all conversations in Beijing and Taiwan  touched on China’s equity markets.

Many others have written much better articles than me on where we are and why the market is expensive.  The headline Shanghai and Shenzhen indexes are up 152% and 191% in the last 12-months.  One of the big drivers of demand for equities is new retail investors opening accounts and pushing up prices. 

However, trying to predict short-term market direction is not something I am at all qualified to do.  I don’t think anybody is.  

Momentum seems like a safe bet.  Until it isn’t and stock prices and high valuations come crashing down.  
However momentum is the default opinion of most.  

Back in Hong Kong, most I’ve talked to in the financial community stick with momentum and remain bullish on China equities.  Despite the high valuations many are expecting the Mainland Chinese government to continue to lower interest rates, expand credit, and adopt pro-market policies or tactical decisions that could/should keep the equity party going.  I’ve only heard of one person selling all his Hong Kong and China exposure and this could have been more of a rumor than fact.

In addition to Hong Kong’s finest financial minds, investment guru Jim Rogers reportedly thinks China’s markets should continue to do well.  He’s expecting the Shanghai index to hit 6,000, an almost 20% increase from where we are now (article here).

One line of thinking is that China’s equity market performance in the next few years could be driven by its leadership cycle.  I’ve written about political changes and their effects on the markets before (blog posts here and here). As noted in those blogs, the US equity market tends to do well in the second and third year of the four-year presidential cycle. This is when political uncertainty tends to be at its low point. 

Could it be similar in China?  China's last top level political change was in fall 2012, so it has another two and a half years in its current five year political cycle.  Assuming the market discounts the future by six to nine months, and using the US political cycle analogy, then China’s equity market should remain strong through the fourth quarter of 2016, or about another 1.5 years. 

Different Markets 

Valuations of China listcos depend on ownership and where they are listed.

Let’s start inside China.  The mega cap state-owned banks and their disproportionately large weights in the narrow indexes mean that the Shanghai Stock Exchange 50 Index is trading at a reasonable 13.0x earnings.  For instance two of these mega-caps, Bank of China and Agricultural Bank of China, are trading at very reasonable PEs of 6.0x and 8.9x respectively.

However the broader 380 Index is trading at a PE close to 54x according to the Shanghai Stock Exchange.  This is four times higher than the 50 Index.

What this means is that the headline and the narrower indexes make Shanghai's headline valuation attractive despite the broader market being expensive. 


Shanghai Stock Exchange

SSE180
Index
SSE 50
Index
SSE 380 Index
PE Ratio
15.6
13.0
53.9
Source: Shanghai Stock Exchange Website (figures above from end May 2015)

Shenzhen’s valuation is even higher with its main board stock trading at a PE of 42x.  This goes up to 82x and 136x for the SME and Chinext exchanges respectively.

A few months ago I posted a blog outlining the reasons why I think Shenzhen is the world's most dynamic city (post here here).  I still feel this way, and by the dazzling heights at which they’ve bid up the local stock market, I suspect the locals feel my cheerleading is way too conservative.

Shenzhen Stock Exchange

Main Board
SME
Chinext
PE Ratio
41.8
81.6
136.9
Source: Shenzhen Stock Exchange Website (9 June 2015)


Hong Kong is not expensive however.  At a PE of 11.5x the Hang Seng index is not very expensive and the China Enterprise index is even cheaper at 10.1x.  Much like its smaller company brothers in China, Hong Kong’s Growth Enterprise Market is at a hefty PE of almost 90x.

Hong Kong

Hang Seng
Hang Seng China Enterprises
GEM
PE Ratio
11.5
10.1
89.8
Source: Hang Seng and GEM Website (as of month end May 2015)

Where to Look?

Another way to look at the situation is to figure out where to look for value. Is there hidden value masked behind the broad market indexes? To do this we divided all listed companies above US$100m in value into buckets based on their PE ratio. 


The results are in line with the valuations of the headline indexes. 


It is most difficult to find value in Shenzhen. Out of the 1,435 Shenzhen listcos of which our expensive data provider has information, only 1 is trading at a PE of less than 10x. Over 800, or close to 60% are trading at PEs of over 100x!

In Shanghai there are only 5 stocks trading at a PE of less than 10x, but 353, or 43% trading of the total, trading above 100x.

In contrast there are almost 300 companies in Hong Kong that are trading at PEs below 10x. This is just below the 26% of the total that we have data for. About one third are trading at PEs between 10-20x. Only 7% are trading above 100x.

Taiwan has richer pickings for value-oriented investors with 72% of its USD100m+ market cap companies trading at PEs less than 20x.


Number of Listcos > US$100m Market Cap
PE Ratio (x)
Shenzhen
Shanghai
Hong Kong
Taiwan
<10
1
5
292
109
10 - 20
32
31
354
279
20 - 50
174
200
238
121
50 - 100
393
222
67
12
>100
835
353
83
13
N/A
247
178
389
65
Total
1,682
989
1,423
599













Source: Yuan Asset Management, FactSet


Tech Bubble 2.0?

Ex-SOE banks Shanghai and all of Shenzhen certainly seem like they're in a bubble. The vast majority of companies in both are way too expensive for my liking.

However the high valuations in the Mainland are making it an attractive place to list. According to a PwC report, 57% of Mainland China companies that went public last year chose either Shanghai or Shenzhen instead of Hong Kong or the USA. 


The current situation bears some resemblance to the tech/Internet boom in the US in late 1990s with TMT and new technology stocks being some of the highest flyers in China these days (article here).

Like their American counterparts in the late 1990s listed companies are changing their name to boost their attractiveness (article here). A few days ago Jun Yang Solar announced its intention to change its name to Jun Yung Financial Holdings (article here).


Party On?



China is clearly changing.  Its economy is starting to mature.  It's becoming more service-oriented.   People are enjoying their lives rather than just working.  These are all good things.  Part of the rise in services includes a robust finance sector which continues to liberalize and extend credit to more borrowers.

My gut feeling is that China's stock market party will continue.  But I really don't know.  Valuations in Shenzhen are in nose-bleed territory and Shanghai is getting there.

In contrast, there are still selected value stocks in Hong Kong and Taiwan.  Many mid- and large-cap stocks in both markets are trading at reasonable valuations.

In my opinion the credit cycle is still in expansion rather than contraction as more feel comfortable taking on debt and there are more companies being set up to provide it.

One thing I'm confident of is that China's slowing economy is unlikely to affect equity performance.  As shown in the chart below, except for the very long term, the economy has very little correlation to stock market performance.  This is in line with academic research and every stock market I've looked at.  GDP growth is almost irrelevant in stock market performance except for the very long term. 


I think one should be prepared for a crash in China's go-go domestic markets.  Knock-on effects could spread to Hong Kong and the rest of Asia.  Hopefully any such crash - should it ever come - does not leave much damage in its wake.

As a friend once said, 'Hope for the best. Prepare for the worst'.














Note that graph above is on a logged scale. Blue line is nominal GDP growth. Red, green and yellow lines indicate nominal price returns on Shenzhen, Shanghai and Hong Kong headline indexes respectively. Notice how erratic stock market indexes are compared to the more steady GDP growth. (Source: FactSet, Yuan Asset Management)

4 comments:

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