“In the stock market, the most important organ is the stomach, it’s not the brain”
A key element of our process is to take on the emotional sources of volatility or price episodes not driven by fundamentals. As we have consistently noted since early 2021, the bear market in Chinese equities is probably not an overreaction, but a genuine re-pricing of trend returns. The regulatory crackdown on billionaire entrepreneurs, property, on-line education and the technology sector in the name of common prosperity might be partly aimed at addressing some of China’s trend growth and demographic challenges. However, it is also clearly intended to centralise control, which is ultimately not a positive development for private (minority) shareholders. Stated differently, it does not always make sense to buy when there is “blood on the streets” if there has been a legitimate destruction of fundamental value.
From our perch, the way price has responded to the purge of market friendly leadership in the CCP and consolidation of Xi’s power is probably warranted and not an emotional overreaction. While some of the recent challenges facing Chinese economy and equity market have been cyclical, for example, the slowdown in credit growth and persisting with COVID zero, there is also evidence of secular deterioration in growth (and profits from a stock market perspective). MSCI China’s trend return on equity (profitability) has been slowing since 2011 and it has accelerated, exacerbated by cyclical factors, over the past 2 years. The recent trend is also in sharp contrast to US return on equity, which has accelerated over the past 2 years (until recently).
The other secular factor that has weighed on the Chinese economy and stock market is leverage. Total Corporate debt in China is 218% of GDP, which is not dissimilar to where Japan’s private sector debt peaked in the early 1990s. The challenge is that debt is inflationary when taken on and deflationary when paid back. While efforts to reduce leverage in sectors of the financial system like real estate have been warranted, it has put downward cyclical pressure on growth.
On the positive side, the credit impulse or rate of change in credit growth has started to improve after contracting in 2021. Clearly China’s government will likely start to prioritise growth. Hopefully, the administration will start to ease COVID restrictions early next year after the Lunar new year holiday. That said, we remain concerned about secular growth looking further out given trends in population (demographics) and productivity (debt required to produce a unit of GDP). Cyclically, the recent gradual improvement in the credit impulse, ought to be positive for Chinese and regional equities next year (chart 2).
Notwithstanding the observation above that the recent price action might be warranted, it is notable that both MSCI China and Hong Kong equities are trading at single digit price to earnings ratios (chart 3). Indeed, the offshore markets are close to the lowest valuation multiples since the early 1990s trough (the Hang Seng Index trades at 6 times current earnings). The absence of market-orientated reformers in the newly formed leadership is a warranted reason for a higher equity risk premium (or lower valuation multiple). It might even be a legitimate reason to avoid Chinese equities all together for some investors (push back we have had from a number of investors this year).
However, our sense is that investor pessimism is now widespread and extreme. It might even be described as revulsion. We would also suggest that some key state-owned (or influenced) enterprises critical to China’s economic recovery will likely benefit from the development vision of the new leadership. Although it feels deeply uncomfortable, the current episode is probably an opportunity for investors with a strong stomach. To be clear, we have a modest exposure relative to a typical benchmark and remain selective in what we would take on. The companies we hold on the long side, have superior cash flow returns and very low balance sheet leverage.