China bubble or not? - December 2007
A near 20 percent correction in four weeks has wiped $700 billion off the Shanghai Stock Exchange, making global investors nervous about a possible China meltdown. Considering the 132% run of the Shanghai Composite in 2006 and a subsequent 125 percent run in 2007 before the current pullback, a bubble theory has ample room to develop.
The question is this. Is there a bubble and if so how to hedge against that?
The short answer is this: there is no China bubble but we give you tips how to minimize your exposure to the most risky stocks and sectors.
Based on different calculations, the latest fall had lowered the average price-to-earnings (P/E) ratio of 300 large-cap companies listed in Shanghai and Shenzhen to 33 times 2007 forecast earnings and 28 times 2008 earnings. This is somewhat high compared to the DJIA's 16.7 average P/E. Shanghai, a place where U.S. investors have no access to and is trading independently from the world markets, is an expensive place to invest due to large demand for shares in China yet supply is tight. A long list of large companies are still waiting to get listed in Shanghai. Among them are the world's largest mobile carrier by subscriber base China Mobile (NYSE:CHL) and China’s offshore oil giant CNOOC Ltd. (NYSE:CEO).
The good news is that U.S. listed Chinese stocks follow more conservative Hong Kong prices and valuations not Shanghai.
As a result, large cap NYSE listed Chinese ADRs are trading at 22.0 P/E, lower than average P/E for any other major China stock index. Again, NYSE listed Chinese companies follow Hong Kong trading characteristics including valuations where average P/E is still a modest 24.4.
NASDAQ listed Chinese ADRs are trading the most expensive relative to earnings and as such they are the most vulnerable during turbulent times.
Considering that valuation for NYSE and Hong Kong listed Chinese companies is not far from the average P/E for the DJIA. we don't think there is a China stock bubble.
When you think of the China stock universe, consider this. How many big global companies have seen economic growth of 10 percent or more since 2002 like China? At this point the risk is on the upside instead of the downside.
I am of the view that current pullback is more of a U.S. sub prime related volatility issue than anything else. If you look up 'Strong stomach needed' article within the August 2007 Newsletter, you find that Chinese stocks are 2 and a half times more volatile that their U.S. counterparts. And our findings are well supported by current market statistics.
Since October 2007, the S&P500 lost just about 10 percent, with the Hang Seng following with a 25 percent drop. This is exactly that 2.5 times volatility that we predicted. Actually, the iShares FTSE/Xinhua China 25 Index (FXI), the best proxy for the U.S. listed China stock universe, lost 35 percent making it an attractive play at this time.
Fanning out concerns about a China meltdown is important but there are some problems with Chinese stocks that we want you to be aware of.
For one, as we just pointed out NASDAQ listed Chinese ADRs are expensive relative to earnings. In a nervous market, you may want to trim your exposure to those names.
For two, recent IPOs of Chinese companies on U.S. exchanges are small cap, immature enterprises with no significant earnings history. It is hard to know who is legitimate. They all come with sound business plans and portray huge potential, yet what we have learned over the course of the years is that potential alone means nothing. Companies have to DELIVER profits.
For three, earnings for some of the companies have been partially generated by the rise in stock values because they have invested in the market. When the market went up, this paid off well but now that the market pulled back, they will face earnings growth slow down. One of our favorite stocks, China Life Insurance (NYSE:LFC) is exposed to this problem. The Company reported investment related net income of $5.4 billion or around 38 percent of total revenue for 2007 H1. As a conclusion, we suggest investors avoiding LFC under current volatile market conditions.
And finally, some of the Chinese companies have relatively small float or percentage of tradable shares. As a result, demand for such shares exceed supply resulting in artificially high valuation. Petrochina (PTR) is a perfect example of this phenomenon. CNPC, parent company of Petrochina, still owns approximately 85 percent of all the shares, leaving only 15 for investors. No wonder Chinese domestic investors pushed valuations sky high at the IPO in Shanghai, lifting theoretical market cap above $1 trillion. But again, this is an artificially inflated number derived from Shanghai and has got more to do with float than with actual valuation. Looking at the valuation of Petrochina in the NYSE, the stock is trading at 16.7 P/E not much higher than Exxon Mobile’s P/E of 12.6. Again, not a China bubble but an issue that we wanted to touch upon, especially after headlines that Petrochina became the first company ever to reach $1 trillion in market cap. Our conclusion is this: Petrochina can be very expensive in Shanghai and seem like a bubble yet it is trading at a relatively modest valuation on the NYSE. Accordingly, U.S. investors can ignore the high valuation in Shanghai.
Again, current market turmoil in China is primarily attributed to U.S. related sub prime mortgage problems. And just how much the Street weights on Hong Kong's Hang Seng Index [HSI] is clearly indicated by the following chart. The chart lays percentage change in the DJIA and the HSI next to each other. The white ovals on the top chart represent significant market days for the DJIA. White markings on the bottom indicate next day open for the Hang Seng, the reaction to the big DJIA day, relative to previous day close.
As the chart demonstrated, big market days in the U.S. are always followed by a yawning gap in Hong Kong. If you had known that U.S. markets have a tremendous impact on Hong Kong trading, this chart is the proof.
Concluding that the current illness in the China stock universe is a derivative of the weakness in U.S. equity markets, we think it is a fair assumption that as soon as markets in the U.S. stabilize, Chinese stocks will soar. These stocks are driven by strong corporate earnings on the back of China’s overall economic growth. As long as GDP growth in China remains around 10% a year, Chinese equities will remain attractive investment options.
To understand the depth of current pull back of Chinese ADRs, let's take a look at a snapshot from the daily 'Pre-Market Report'. This chart is a graphical representation of how Chinese ADRs look from a technical point of view at the moment.
Not surprisingly the overall indicator, first one in the row, is bearish. Stocks are much closer to 52 week lows than to highs with no stocks within the Chinese ADR universe trading above the 20 day-moving-average (DMA). This is a significant development, a reading that the correction is universal. Most of the stocks are still trading above their 200 DMA, an indication that the current pullback is still a short-term development. As the Up/Down Volume section reveals, current drop takes place under heavy volume, an another bearish sign. The only somewhat positive sign is that the Relative Strength Indicator (RSI) is getting to be oversold, a position when markets are likely to turn around.
Still, the overall picture is far from rosy and is more painful for the investors who purchased stocks near the high.
To put latest correction into perspective, let's take a look at the chart on this page. We used the iShares FTSE/Xinhua China 25 Index (FXI) to track the overall performance of the U.S. listed China stock universe. As the chart reveals the current correction of 23.2 percent is not without precedent. The second biggest drop just occurred at the beginning of the year after a stellar rally in late 2006. Still 20 percent plus corrections are not common place and should be noted that there have been three major corrections in year 2007 alone, more than in any year before combined.
What does it tell us? Let's put these corrections into perspective first. As the chart demonstrates, there haven't been so sharp rallies before 2007 either, so dramatic corrections should not come by surprise either.
Also, current sickness in the U.S. markets is something that cuts right into the heart of the economy: consumer spending. Since consumer spending is responsible for two thirds of economic activity, a slight decrease in spending sends a chilling message to Wall Street. From this respect, the Street is nervous and for a good reason.
Another factor that amplified such a dramatic contraction of Chinese ADRs is coming from the disappointment as a result of the delay of the 'through train' program. Under the original proposal, Beijing was to let individuals as well as institutions and funds to invest in Hong Kong directly. This was believed to channel significant money flows to Hong Kong from Shanghai where valuation of Chinese stocks was lower. Based on this assumption Chinese companies listed in Hong Kong started to rally boldly. Think of the 30 percent share price jump overnight of Aluminum Corp. of China (2600.HK)(NYSE:ACH) on Aug 27.
But as investors learned that Beijing put the brakes on the program and was effectively terminated, a correction for Hong Kong and subsequent NYSE listed Chinese stocks was ensured. From this respect, U.S. related problems could not come at a worst time.
Still, NYSE listed Chinese ADRs are delivering robust earnings growth and as such a bounce back is just a matter of time.
