Asia

After 2018’s sharp drop, are Chinese stocks cheap enough?

Chinese stocks go through frequent cycles of boom and bust. The market saw major peaks in October 2007, May 2015 and January 2018. The first two of those were followed by substantial falls, which turned out to be excellent buying opportunities. Chinese stocks are down substantially over the past year. Is now a good time to buy?

The MSCI China index is down 23% over the past year, measured in US dollars. The MSCI China A Index, which consists only of A-shares, is down 33% in dollar terms. (A-shares are those traded on the mainland Chinese stock exchanges in Shanghai and Shenzhen, and denominated in Chinese renminbi yuan.)

Given these falls, is now a good time to pick up Chinese stocks? Or, more specifically, is there a particular index of Chinese stocks that’s attractive?

Chinese stock markets are complex. Apart from the A-shares, there are also B-shares in the domestic market, which are denominated in US dollars. The domestic Chinese stock markets were only relaunched in 1990, having been shut down in 1949 after the Communist Revolution.

As well as that, many mainland Chinese companies are listed in Hong Kong. That’s also part of China, but with different regulations – a legacy of its time as a British colony (until 1997). The Hong Kong Stock Exchange was formally set up in 1891. Outside of Hong Kong, many other Chinese companies have chosen to list in other countries such as Singapore and the US.

In the case of US listings, investment banks were keen due to the much higher IPO fees charged in the US market, when compared with the rest of the world. A few years ago, it also turned out that certain unscrupulous, third-tier investment banks were teaming up with fraudulent Chinese companies to list Chinese stocks in the US, often via reverse mergers into existing US companies.

In my opinion, there are two basic principles that all stock investors should follow in China: stick with the big stuff and stay highly diversified. It’s simply too risky to go too far into the weeds of the small cap or mid cap worlds. Even where accounts are honest, disclosures are often poor. And Chinese capitalism is so wild that diversification is paramount. Investors can capture the economic growth, but they’re best to do it with a broad basket of stocks.

The easiest way to get such access is via the MSCI China Index. This mainly consists of Chinese stocks traded in Hong Kong or non-Chinese markets, and denominated in Hong Kong dollars or (mainly) US dollars. It also includes a small amount of A-shares. [Note: The Hong Kong dollar is effectively pegged to the US dollar.]

Below is a chart of the MSCI China index since December 1992, which is when it started (figures are calculated in US dollars and include dividends).

MSCI China index since December 1992 (total returns)

Source: MSCI

The first decade was wild. That’s not surprising after decades of communism, in a country where gambling is popular, and where there was little for people to do with their savings. Brokerage offices were more like betting shops than places to invest. Literally. They actually looked like betting shops, with rows of day traders, armed with pencils and paper pads, studying screens of stock tickers.

The index lost over 80% between 1992 and 2002, bottoming out around the time of the SARS epidemic in 2003 (which I remember well, since I’d moved to Hong Kong in late 2002). But, since then, there’s been a clear secular bull market, in keeping with Chinese economic growth.

Investors that bought the index in December 2005, which was already twice the level of the 2003 bottom, made 9.8% a year since then, with compounding and despite the recent falls. That said, the overall uptrend has clearly been punctuated by booms and busts.

What’s in the MSCI China index?

Nowadays, the MSCI China index has 459 constituents, although the top 10 stocks make up 52% of the index market capitalisation. This is largely due to two large e-commerce companies: Tencent (16% of the index) and Alibaba (12%). After that, the next largest constituent is China Construction Bank (5%).

The index had a price-to-earnings (P/E) ratio of 11.9 at the end of December and a dividend yield of 2.4%. But those averages hide two particular extremes.

On the one hand, are those two big e-commerce companies. Tencent has a P/E of 32 and dividend yield of 0.3%. Alibaba has a P/E of 46 and pays no dividend. Because of their big index weights, these act to lift the overall index P/E and reduce the index dividend yield.

On the other hand, 23% of the index is made up of Financial stocks, which are mostly banks. I looked at the six largest of these, which are 17% of the index. Their weighted-average P/E is just 6.4 and the dividend yield is 5%. These do the exact opposite of the internet giants: they pull down the index P/E and drive up the index dividend yield.

As for the rest of the index, it’s somewhere in between. Most likely, the P/E is in the high single digits, by my estimates.

Overall, the companies in the index look pretty profitable. Return on equity works out at 13%. That’s about the same as for the MSCI All-Countries World Index (ACWI), made up of 24 developed and 23 emerging markets. But the MSCI China is 23% cheaper on a P/E view.

[Note: You can work out return on equity by dividing price-to-book (P/B) by P/E. That’s the same as E/B, or earnings divided by book value (aka shareholders’ equity), expressed as a percentage.]

The index dividend payout ratio works out at 29% of earnings. That means 71% of profit is retained and added to equity capital. If the return on equity remains constant, and that new capital is invested at the same rate of return, this points to 9.2% annual profit growth, in the long run (71% x 13%).

That sounds reasonable, since it should be roughly in line with nominal GDP growth in future. Corporate profits tend to track GDP growth over the long term. (Note: not the real, after-inflation GDP growth rates that are usually quoted.)

Adding the 2.4% dividend yield points to average annual returns of 11.6%, over the long run and measured in renminbi yuan. That sounds pretty attractive.

Some concerns

Of course, there are things to be concerned about in the short term. Around 19% of Chinese exports went to the US in 2017. If the US decides to keep / increase / extend stiff import tariffs on Chinese goods then many Chinese companies will take a hit. On the other hand, the trade tensions may disappear within weeks.

The other big issue is whether there’s an impending debt crisis in China. In particular, levels of Chinese corporate debt have risen swiftly in recent years, as a percentage of GDP. Apart from the general economic risk this implies, it could cause big problems for Chinese bank profits, which are a big piece of the index. On the other hand, Chinese bank stocks are already trading very cheaply, typically with P/E ratios of 5 to 6.

On balance, the MSCI China index looks attractively priced at this level, at least for the long-term. But investors should bear in mind the high concentration in quite richly priced e-commerce stocks (Tencent, Alibaba) combined with cheap bank stocks, but with exposure to corporate lending.

For those interested in investing in Chinese stocks, after last year’s falls, an easy route in is via the iShares MSCI China ETF (Nasdaq:MCHI).

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.