Enter the Dragon & the Third Element
This year we enter the Zodiac year of the Dragon. Let’s hope it is a lot more auspicious than the last three years for Chinese assets. In a recent note (see “how much can a panda bear”) we highlighted the widely appreciated bearish prevailing bias on Chinese equities. As we have noted, there are three elements to our process. First, have the odds (valuation) on your side. Second, identify a divergence between price, beliefs and fundamentals (profits). Third, take an asset on when there has been a phase of emotional capitulation or rapid (waterfall) price action to the downside. Chinese equities fit these criteria. Our sense is that the third element is now underway, especially in onshore equities.
The CSI 1000, which includes smaller companies, has experienced extreme waterfall price action on the downside (chart 1) after a long bear market. The selling has been amplified by structured product related flow (“snowballs” – because the losses snowball) where investors have been knocked in (forced in) at unfavourable levels compounded by reflexive dealer related hedging and some levered account selling. Our understanding is that this process is well advanced, although might not be completely washed out yet. Of course, that is evident from the price action itself.
The fundamental bear case is well appreciated. The valuation is extreme. The Shanghai Composite now trades at 4.7 times two year forward earnings. The third element we have been waiting for is the capitulation or forced selling from levered investors and redemption related flows. The major push back on the bull case (we often hear) is the absence of more forceful policy action that might lead to a fundamental positive inflection point in growth.
We are sympathetic to that point and recently outlined that the currency and total debt were genuine constraints on aggressive policy easing (see “I would recommend you panic”). We also noted this week that a further phase of dollar strength and a higher path for short term dollar rates could be a sustained challenge for emerging markets. The good news is that the valuation (odds or margin of safety) is extreme and the third element – capitulation related selling – is clearly underway. The best investments are often made from a position of deep discomfort. The long side of China feels incredibly uncomfortable today. That’s probably why it is now a good idea.
How Much Can a Panda Bear?, January 18th 2024
It is an understatement to say that the prevailing bias is bearish on Chinese equities. We can’t recall a phase (apart from 2008) when the consensus was more bearish on the market. Perhaps it was worse in 1997, but the current mood feels utterly hopeless. There are three key elements to our process. First, have the odds (valuation) on your side. Second, identify a divergence between price, beliefs and fundamentals (profits). Third, take an asset on when there has been a phase of emotional capitulation or rapid (waterfall) price action to the downside. Chinese equities fit these criteria.
First, the Shanghai Composite trades at around 10 times earnings (chart 1). That is low in outright and relative terms (roughly half the valuation of the US stock market). The last time US equities traded at 10 times earnings was around 1982, just before the great bull market. To be fair, as we often note, valuation is conditional on cash flows, profits, and balance sheets. Earnings growth has been weak for legitimate reasons (the episode in real estate and consumption). Nonetheless, I am old enough to remember when the Shanghai Composite traded at 55 times earnings and consensus beliefs on growth were the opposite of today’s pessimism.
Second, from a pure price perspective the current bear market has lasted almost three years. The drawdown from the peak is almost 50% and the recent price action has taken on a waterfall-like character (chart 2). That type of price action is often a sign of capitulation in beliefs and or levered investors being stopped out. Our understanding is that both are true (redemptions of long only allocations and levered/structured product investors being stopped out). This type of capitulation is often an opportunity for liquid investors with a longer time horizon.
On the negative side, as we have noted for some time, many of the secular challenges are legitimate. That is evident from the macro news flow in the real estate sector and from the price action itself (chart 3). Note how the price action in the real estate sector has accelerated to the downside following a brutal bear market. In previous episodes since 2008, typically weakness in the real estate sector (around 25% of GDP) was met with an acceleration in the pace of credit growth. However, in the current episode, the credit impulse has been anaemic. Moreover, even if credit was available, demand remains weak given excess supply of real estate and outright defaults. You cannot have mean reversion if a business goes bust. Stated differently, with China’s debt total debt load reaching 300% of GDP, it might have entered a Japan-style liquidity trap or balance sheet recession. The recent asset price weakness and capitulation has likely been amplified by the absence of more assertive policy efforts.
Nonetheless, our sense is that positioning, sentiment, beliefs and valuation now reflect the fundamentals noted above. We prefer the technology and large platform stocks. We are acutely aware of the regulatory and policy interference in that sector as well. However, we would note that Tencent, for example, has zero net debt, gross margins at 50%, $6.6 billion USD in free cash flow and trades at 14 times 12-month forward earnings. The recent price action is not a complete emotional overreaction, because some of the challenges are legitimate. However, there are signs of capitulation and the valuation odds have become interesting in key stocks and sectors. The best trades are often made when you feel deeply uncomfortable. It feels horribly uncomfortable in Chinese equities now.