China - time for a bounce back

With the market in the midst of a deep bear market, investors are naturally wondering whether A-shares are finally a ‘buy’ again. Alan Landau, of Marco Polo Pure Asset Management, gives his view

China’s domestic equity markets in Shanghai and Shenzhen are perhaps the least understood major markets in the world. More often than not it has been portrayed in a less than flattering light, with a particular focus on the considerable fluctuations in market performance.

From 1990, to the market peak in 1992, the Shanghai A-Share Index climbed an incredible 1,412% (stories of cash-only trading accounts still float around).  Then in the space of two years the market crashed 77%, rocketed up 353% and then fell again by 80% to its 1994 market low.  The index then climbed 629% from that market low to the 2001 peak nearly seven years later.  From the 2001 peak of 2341 points, the index shed nearly 55% reaching a low of 1047 points in 2005.  Then the market began another of its bull runs, this time in the full light of international view.  In October 2007, the market peaked at 6429 points, an astounding 514% return in only two years.  Even more quickly, however, the market began a wrenching decline, falling almost 67% in less than a year.

There are a number of ways to rationalise these erratic moves. First, domestic investors have few alternatives other than investing in A-shares.  While there is a small corporate and government bond market, and a tiny derivatives market, banks deposits are the main alternative to equities.  When prices for A-shares hit the highs, investors therefore have few options: they can stay in equities, go to cash, or buy real estate.  Most importantly, they cannot seek lower priced securities in New York, London or Hong Kong.  Of 52 companies with both an A-share and an H-share listing, currently only 12 A-shares trade at discounts to their H-share sisters.  Mainland Chinese cannot purchase ‘discounted’ H-shares (and Hong Kong investors cannot short the ‘premium’ priced A-shares) so the distortions that exist cannot be rectified through simple arbitrage mechanisms common in developed markets.  Until the Chinese government reforms its currency regime, allowing the Renminbi to be freely exchangeable, and opens its securities markets to the free movement of capital, A-shares are likely to trade at a premium to internationally traded equities.

The second reason the A-share market has been prone to extreme volatility is that it has been fueled by dramatic earnings growth accelerations and decelerations.  As recently as 2007, earnings grew across the entire market on average over 57%, which was all the more astounding given the fact that earnings growth exceeded 53% in 2006.  Yet, in 2002, earnings grew at less than 1%.  Even in 2008, after two years of sky-high earnings growth, corporate earnings are widely expected to grow by at least 25% across the nearly 1600 companies making up the A-share market.

The third reason for Shanghai’s volatility is the make-up of the investor base in the A-share market.  In a country where more than 95% of the investing public speak the same language, read the same government -controlled newspapers and watch the same government news, it’s not surprising that investors move from overly bullish to overly bearish in tandem.

Whatever the reason for the volatility in the A-share market, the market has traded at high market multiples.  While the S&P 500 has averaged around a 15 PE historically, the Shanghai A-Share Index has averaged a PE of over 30 (although other high growth markets, including the Nasdaq, traditionally do trade at higher multiples). This PE of course has had significant variability over time, but has almost always been higher than markets in the developed world.  The chart below illustrates the market weighted PE of the Shanghai A-Share Index from 1992 to the present.

Note: PE calculated on a quarterly basis using full year calendar earnings.

What is striking about this chart is that for almost its entire history the A-Share market has traded at comparatively high earnings multiples, at one point in 1999 reaching a PE of almost 120x.  While flirting with a 15 PE in 1994 and 1995, the PE of the market did not again see these levels for nearly a decade.  During the bear market of 2001-2005, when the A-share market was facing many challenges (SARs, the reform and restructuring of state owned shares, and the protection of private property, which caused a drain on stock market liquidity in favor of real estate ownership), the A-share market was at all time PE lows, but still only saw a PE slightly below 15x briefly in 2005 and 2006.

Today the A-share market is again in the midst of a painful correction that has seen  multiples compressed to a 2008 estimated PE of 15.  According to Jun Ma, Chief Economist for Greater China at Deutsche Bank, the market’s current valuation is “reasonable”, assuming the economy does not get much worse than forecasted.  Ma echoes the concern of many market participants who are worried about a slowing Chinese economy and a consequent slowing in the growth of corporate earnings.  Wendy Ma, ABN AMRO’s Head of China Research, though thinks that these concerns are overblown.  According to Ma, “China has sufficient domestic savings to support internal growth, so long as regulators are not fixated on inflation and do not overly tighten the economy”.  In fact, for the first time in more than two years, China has begun to loosen.  While no drastic measures have yet been taken to reverse the tight monetary conditions prevailing in the country, in July, in a move to reinvigorate small and medium sized enterprises, the People’s Bank of China increased bank loan quota for regional banks by 10% and national banks by 5%, which should have a stimulative effect on the economy.  In addition, the government announced in August that a reform of the VAT tax system will be implemented.  Given that China has spent the last two years raising interest rates and bank reserve requirement ratios, and lowering lending quotas, the government has substantial room to loosen monetary policy to spur domestic consumption and fixed asset investment.  The Chinese are also running a large fiscal surplus that can be used to spur expansion of the economy.

As China transforms itself from an exporter to a consumer, domestic consumption will continue to play an ever more important role and be a key driver of corporate earnings.  In addition, fixed asset investment, the second biggest contributor to China’s GDP, has been very strong, with the rate of growth exceeding 26% in the first half of 2008 year-on-year.  As the global economy slows and export growth decelerates, expect China to stimulate the economy through further expansion of FAI through an increase in government spending to favored industries.  FAI in the agriculture sector, a top priority for Beijing as a result of China’s recent bout with food inflation, was up nearly 70% in the first half of 2008.  The government has deep public coffers available to stimulate a number of key sectors in 2009.

ABN AMRO’s Ma believes that most investors have been focusing on the negatives and ignoring China’s many positives.  She’s looking for a short-term rally as “perception closes the gap with reality”.  More importantly, a return to a bull market is likely before the second half of 2009 as stimulus measures undertaken by the Chinese government and the expansion of domestic demand materializes in the macro numbers and corporate financial statements.  While it is too early to say that the A-share market is on the verge of a V shaped market rebound, prospects are improving.  Investors who believe in China’s long-term story may want to get ready for one of the A-share markets characteristic bull markets. How do you protect on the down side?