Asia

The most important asset class in the world (Part I of II)

Shanghai Skyline

Spend an evening wandering through any large Chinese city and you are likely to be impressed. Giant new skyscrapers, glittering with multi-coloured light displays, have been springing up for the past two decades. Manhattan’s famous skyline looks positively dull by comparison. But is China experiencing a massive property bubble?

Chinese real estate is probably the most important asset class in the world these days. The massive building boom has created huge demand for all sorts of commodities and construction materials, such as iron ore (for steel), copper (for wiring), zinc (used to protect steel against corrosion), cement and so forth. Whether that demand continues has huge implications for commodity prices and commodity exporting countries such as Australia, Canada and Brazil.

Real estate is an important part of the economy in most countries. Its significance reaches far beyond construction companies and their workers.

Real estate agents are needed to sell properties. Furniture must be sold to furnish them. Private wealth is invested in property, and when prices go up people feel better off and spend more on luxuries. And banks lend mortgages to buyers, taking fees up front and collecting interest charges for many years to come.

When major real estate bubbles burst they create a huge drag on economies, as seen in Japan over the past 23 years, and more recently in the USA and much of Europe.

Construction grinds to a halt. Workers are laid off. Real estate agents shut offices. Furniture stores close down. Owners default on their mortgages. And banks take big write downs on their loans and mortgages, limiting their ability to keep credit flowing to all sectors of the economy.

Since China is the world’s second largest economy and a major driver of commodity demand, whether or not the country has a real estate bubble is a big deal. A collapse in Chinese property prices will have widespread repercussions.

…Chinese stocks have a P/E of just 7.1 and an attractive dividend yield of 4.7%. By most measures that makes China a screaming “buy”, second only to Russia…

This perception of a bubble and the risks it presents are reflected in the Chinese stock market. According to the Financial Times, Chinese stocks have a P/E of just 7.1 and an attractive dividend yield of 4.7%. By most measures that makes China a screaming “buy”, second only to Russia among the major markets, with a P/E of 5.8 and dividend yield of 3.7%.

The Chinese stock market experienced a major bubble in 2007. It has basically been in a bear market ever since, as the following chart of the Shanghai Stock Exchange Composite Index shows.

Shanghai Stock Exchange Composite Index

The Chinese stock market experienced a major bubble in 2007. It has basically been in a bear market ever since.
The Chinese stock market experienced a major bubble in 2007. It has basically been in a bear market ever since.

So Chinese stocks look cheap on the face of it. But there’s a big catch…maybe. Chinese stock indices have a large weighting to the big domestic banks. There are four giant state-controlled banks in China (Bank of China, Industrial and Commercial Bank of China, China Construction Bank and Agricultural Bank of China), and many smaller banks.

ICBC alone had assets of US$2.9 trillion at the end of December. To put that into perspective Bank of America, which is the largest US bank, had assets of US$2.2 trillion.

Each of the “big 4” banks is huge, with tens of thousands of branches, vast armies of staff and huge balance sheets. ICBC alone had assets of US$2.9 trillion at the end of December. To put that into perspective Bank of America, which is the largest US bank, had assets of US$2.2 trillion. The other three big Chinese banks had assets between $2.1 trillion and $2.3 trillion each.

This goes a long way to explaining why most China stock index ETFs (exchange traded funds) have a large weighting to the financial services sector of 30-40%. “Financial services” also includes insurance companies, stock brokers, fund managers and – bizarrely, but by convention in the fund management industry – real estate companies. But in China’s case it’s the banks that dominate this sector.

On the face of it the financial giants look even cheaper than the broader stock market. The average P/E ratio of their stocks (shares) is just 5.4 and the average dividend yield is a high 6.3%. This is despite consistently fast-growing earnings, high returns on equity (a common measure of profitability) that averaged 18% in 2012, and average leverage (assets divided by equity) of 15.8 times, which is low by international standards.

So something has investors running scared of Chinese banks, which in turn has been dragging down the Chinese stock market. One major reason, although not the only one, is the often talked about bubble in Chinese real estate. But the evidence is mixed as to whether there really is a bubble.

There have been numerous reports in recent years of ghost cities in China. These are massive, planned new centres of population that lack one essential ingredient…people. They are literally deserted.

Rows upon rows of empty houses….vacant apartments stacked to the sky…six lane highways with traffic lights blinking to an imaginary audience…and vast shopping malls with nothing to sell and nobody to buy it.

But China is a huge place, where everything happens on a grand scale. I’m not surprised that in the rush for industrialisation and growth there has been some misallocation of capital. Even sizeable misallocation.

But that doesn’t mean the whole property sector is in a bubble. Far from it. In my next article I’ll look more closely at some of the evidence. It may not be nearly as bad as many claim. In which case, at current levels, could Chinese stocks be a great opportunity for long term value investors?

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.