by James Gruber
The bear case
Questions for bears
The case for accumulating
Risks
What to buy
Late last year, Asia Confidential made a seemingly outrageous call: that junior gold miners would likely prove the great contrarian trade of 2014. At the time, these stocks were the most hated assets on the planet. By a distance. But valuations were at more than decade lows. And many companies were addressing shareholder concerns by booting out bad management, cutting costs and overly-aggressive capital expenditure, as well as focusing more on returns on capital instead of growth. Gold prices didn’t need to rise for many of these companies to provide potentially attractive returns as they were discounting US$700/ounce prices into perpetuity. Since that call, the junior gold miners ETF in the US has rebounded close to 50%.
These miners no longer offer the same compelling “deep value” buying opportunity (though still reasonable). The question for investors now is: what assets do offer such opportunities? Well, Russian stocks may qualify given Ukraine worries have driven market valuations down to a seemingly cheap 5x price-to-earnings ratio. Though tread carefully given earnings and book values have been “juiced” by a 13-year oil bull market. Copper miners may be worth a look also given the extraordinary price action in the copper price of late.
Our focus today though is whether China stocks qualify as potential opportunities following their recent correction. It’s our view that these stocks do offer attractive prospective returns. Not outstanding, but attractive. In other words, long-term investors should consider accumulating them at current levels.
Yes, China’s economy is deteriorating. I’ve been consistently negative on this economy over the past 18 months. But the argument here is that a credit bust is now largely factored into stock prices. The Chinese stock market is down two-thirds from 2007 highs, investor sentiment is at multi-year lows, valuations are close to decade lows and bank prices have more than discounted a crisis.
Sure, there are plenty of risks to this call. Stock market corrections normally end with sharp falls and that may be ahead of us. Events such as further trust loan defaults and a serious property downturn (the next domino to fall) could further dent investor confidence. And the list goes on. Ultimately, however, these risks need to be weighed against the price on offer. In the case of Chinese stocks, the price appears reasonable.
The bear case
The bear case for China stocks is an easy one to make. As almost everyone is making it, I’m not going to bore you with all the gory details. Suffice to say, the case largely rests on these key factors:
1) China is undergoing a credit bust which will almost certainly worsen. As famous short-seller Jim Chanos likes to say with a hyperbolic flourish: China is Dubai 2008 multiplied by 1000.
For some context, let’s turn to a prior post of ours:
“It’s important to understand how China’s economy got to be so big in a short space of time. The speed of economic ascent has no parallel in modern times and it’s been the result of a classic export-led growth model.
What this means is that China has been able to mass produce goods on an unprecedented scale given the appetite for these goods abroad. This has helped lift industrial investment well beyond the level which would be needed if it focused solely on the domestic market. And it’s been aided by a key competitive advantage on the global stage: cheap labor. The end result has been that China has been able to suppress domestic demand and pour resources into investment.
The reason why this export-led model is unsustainable is that China now produces so many goods that the rest of the world cannot possibly absorb them all. China’s gotten to big for its own good, in crude terms.
When the 2008 financial crisis hit, Chinese exports plummeted and the limits of the model became apparent. However, China cushioned the blow by implementing massive stimulus measures. In effect, it sunk even more money into investments, such as infrastructure, property and factories. The problem to this day is there hasn’t been the end-demand for these investments. In other words, export demand has remained soft and domestic demand for goods hasn’t been able to pick up the slack.
And a bigger problem is that the much of the investments via the stimulus were debt-financed, principally to state-owned firms. These firms were deemed less risky by banks.
That’s created an issue for small firms which haven’t had access to bank financing. Given reduced export and domestic demand, they’ve had to resort to financing from outside the banks, the so-called shadow banking system. They’ve had to pay much higher interest rates as a consequence. And it’s widely known that the collateral used for non-bank financing is less-than-solid, on average.”
The reliance on debt to push economic growth has resulted in total China credit to GDP reaching 220%. That means China is now heavily dependent on credit to produce growth.
The worry is not so much the total amount of debt, but the pace at which it’s been accumulating. China credit to GDP has risen by 90 percentage points over the past years, nearly 2x that of other countries prior to financial crises.
In short, history suggests rapid accumulation of credit almost always results in serious financial crises. And China’s unlikely to be any different.
2) The history of transitions away from export-led economic models also makes for ugly reading.
Everyone, including the Chinese leadership, knows that China needs to rebalance the economy more towards domestic consumption. Similar transitions in Japan in 1973 and South Korea in 1991 though led to sharp slowdowns in economic growth.
3) Recent economic data has shown the downturn is gathering pace. Industrial output slowed to 8.6% year-on-year (YoY) for the first two months of 2014, down from 9.7% in December and missing consensus forecasts of 9.5%. Industrial output tracks GDP pretty closely and it was the lowest output reading since August 2009.
Property sales were also disappointing, down 3.7% YoY in January and February combined. And fixed asset investment and retail sales growth slowed too.
There’s little doubting it: China’s economy is swiftly slowing.
4) Further trust defaults are coming. Just over a week ago, the government refrained from rescuing struggling solar cell company, Chaori, after it couldn’t make an interest payment on its bond. This was the first corporate bond default in China’s history.
The fear is that more defaults are coming with 40% of trust loans due to mature during the remainder of 2014. Bank of America Merrill Lynch says the next high risk period for defaults is April through July.
5) Implementation of economic reforms would be a net-negative for GDP growth in the near term. If China is determined to slow investment growth, that’ll inevitably lead to lower economic growth. After all, investment growth has averaged 15% over the past decade, while consumption growth has averaged 9%. Slowing down investment growth means consumption would need to lift significantly for GDP to maintain current rates. And that’s unlikely to happen.
Questions for bears
Here’s the thing: your author agrees with all of the above. And I’ve repeatedly made the case for a China credit bust.
But investing based purely on past or future economic conditions is a tricky and often fruitless game. A recent study by Credit Suisse showed that if you’d invested in emerging markets based on past GDP growth rates, your subsequent market returns were poor. In fact, the countries with the lowest GDP growth have subsequently performed best.
What explains this? Well, it’s simply that countries with low economic growth often have that factored into stock market valuations, and vice versa. It’s the price that you pay for the growth that matters.
This is consistent with data which I’ve seen on the China market. My previous firm back-tested many factors driving China stock market returns and so-called value investing consistently beat other investment styles, including momentum, over short and long-term periods.
In sum, there’s a reason why the vast majority of economists make poor investors. They can make perfect predictions about an economy, including a China credit bust, and still get the stock market wrong.
Price and valuation are the ultimate drivers of future returns. That’s doesn’t mean economic prospects should be ignored though as these can form important inputs on whether risks, particularly tail risks, are factored into valuation.
The case for accumulating
Our call to start accumulating China stocks rests on several factors:
- The Chinese stock market has been one of the world’s worst performers in recent years. Since peaking in 2007, it’s down more than two-thirds. Since the S&P 500 bottomed in March 2009, the S&P has returned 141% while the Shanghai Composite Index has fallen 7%.
- Given that under-performance, it’s unsurprising equity outflows are at multi-year highs. Investors can’t pull their money out of China market fast enough, as the chart below from EPFR shows.
- Valuations are near decade lows. The Shanghai market is trading at 8x earnings and 1.4x price-to-book. Meanwhile, H-shares (China stocks listed in Hong Kong) are trading at 6x earnings and 1.1x price-to-book. These are 1.3-1.5 standard deviations below their 10-year averages.
- China banks are factoring in a credit crisis. This is important as these banks have the largest weighting in Chinese stock market indices. For instance, they comprise 33% of the H-share index. The prices of these banks imply a non-performing loan ratio (NPL) of 7%, versus the 1% reported and 3.2% provisioned in the third quarter of last year. The 7% implied NPL is at the upper end of historical crisis scenarios globally.
- Studies of historical market pullbacks suggest the current correction may be nearing an end.
- There doesn’t seem to any expectation of positive news on the economic front. Marginally positive news is likely to be greeted well by the market. On this front, I was encouraged by the recent government vow to push ahead with financial liberalisation. A pilot scheme to allow five privately owned banks to be set up in various parts of the country will hopefully inject much-needed competition into the banking sector. Deposit rates will also be liberalised within two years – an overdue move. Such announcements aren’t being given much credit but that could change going forward.
Risks
There are a number of risks buying Chinese stocks. Though these stocks are cheap, they’re not at levels of extreme crises of the past. For instance, the China market bottomed at 5x earnings and 0.4x price-to-book during the Asian crisis. This crisis is an extreme example but there are no guarantees that valuations won’t get to those levels again.
News is expected to deteriorate on the economy. Asia Confidential is looking for property prices to soon roll over. This would have significant ramifications as property is the primary collateral for loans/trading.
If this eventuates, economic data could deteriorate sharply and GDP may head to sub-6% levels. That could hurt sentiment as many investors still don’t expect GDP near mid-single digits.
A credit bust would lead to speculation about whether China may endure a Japan-style prolonged downturn. This seems unlikely.
It’s true that there are a number of similarities between Japan in 1990 and China today. Both countries relied on export-led investment models. When these models faltered, both used credit as a substitute to drive growth. There are many other similarities which are worth studying.
But there are important differences too. In 1990, Japan was a much more developed country than China is today. Japanese GDP per capita was 6x greater. This means that the less developed China has greater scope to grow its way out of debt problems.
In addition, Japan’s stock market and real estate bubbles were arguably much larger than China’s. For instance, Japanese stocks peaked at 70x earnings versus China’s 48x (in 2007).
Lastly, Japan had no track record of changing economic models following crises. China does. The large-scale reforms of the 1970s, 80s and 90s are proof of this.
The final risk to buying China stocks is also related to Japan: that of heightened tensions between China and Japan, perhaps leading to war. This eventuality can’t be ruled out but seems remote given both countries are preoccupied with faltering economies.
What to buy
The focus of any buying of China stocks should be on what I term “new China”. That is, stocks in sectors which should benefit from the country’s switch to a more consumption-driven economy.
Internet stocks should be the first port of call. They have many structural tailwinds. China’s internet penetration rate stands at just 40%, about the level of the US in 2000. Only 25% of households have a personal computer, indicating ample room for growth. Lastly, the smartphone installed base, currently at close to 300 million, is expected to hit 400 million in 2014.
Among the Chinese internet stocks, our current preferences are Sohu, Baidu and NetEase. Sohu operates a search engine called Sogou, in which Tencent recently took a stake. Sogou will be merged with Tencent’s search engine SoSo. This should lead to a significant turnaround in Sohu earnings.
Baidu is China’s Google, operating the country’s largest search engine. It’s in prime position as advertising transitions more to mobile devices.
NetEase produces online games. These games have a huge following. The company has also developed its first mobile game and mobile news dictionary. NetEase is hugely cash generative and around 30% of its market capitalisation is now net-cash. That leaves room for share buybacks and/or increased dividends.
The consumer sector is also one to like. While consumer staples are expensive, retailers aren’t. While the latter faces considerable short-term headwinds, some are priced for it. I like Giordano, a pan-Asian discount retailer with significant exposure to China. It has a great track record and sports a single digit price-to-earnings ratio and sustainable dividend yield of +7%.
Finally, Chinese insurers operate in an under-penetrated industry which should benefit as incomes improve. PICC has a stronghold on property and casualty insurance and is reasonably priced.
AC Speed Read
- Following the recent correction, Chinese stocks offer attractive value.
- The Chinese economy is expected to deteriorate further but that’s largely factored into market valuations, which are near decade lows.
- Our preference is for consumer-related stocks, including internet, retail and insurance plays.
- The primary risk to accumulating Chinese stocks is that valuations could reach more extreme levels if the economic downturn gathers steam.
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