How cheap is China? – an update
If China really had had a gigantic bull market, then the tumble of recent months would not have any sensible investor getting ready to buy. But as my chart shows, this simply hasn’t happened. It is only the domestic indices of speculative stocks that soared – in the case of the Shanghai Composite, by 120% from last October to June 2015. So, how cheap is China?
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But look at the poor old Hang Seng index of blue chip HK and China shares – it managed just a 40% gain over the same period and after the crash it is now trading at last October’s level.
Given the bungled way the authorities tried to put a floor under the market, it’s not surprising that most now mistrust all official pronouncements. But last week the government confirmed it wanted to sell off more stakes in State Owned Enterprises. That simply will not be possible until and unless domestic sentiment improves.
Meanwhile the FT reports that the powerhouse factories in South China are struggling to recruit enough workers to keep their production lines for Apple, Benetton and others humming. And retail sales are rising at around 10% and so are wages.
So I think investors should either start investing or add to their China holdings in coming months. Fidelity China Special Situations investment trust, with 30% gearing and at a 15% discount, is my own choice.
But real contrarians ahould be looking at Latin America. Here is an investment that has fallen by 20% over three months, 25-30% over six months and by 35-50% over the past 12 months. This is the one to buy if you want to prove your contrarian credentials.
I have indeed started buying, on a monthly drip-purchase. I have chosen Invesco Perpetual Latin America, an OEIC managed by Dean Newman, IP’s head of emerging market equities who has been managing this fund since 1994. He has seen this movie before. Rollercoasters can go up as well as down.
Performance of the China stockmarket indices
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Chris Gilchrist, October 2015
Time to top up China and EM equity holdings
My recommendation in last month’s editorial column to “buy through the pain” could hardly have been better timed. Chinese stocks proceeded to provide all the pain anyone might have wanted with a vertiginous sell-off, as shown in the chart. The Shanghai market registered a decline of 8.5% on August 24th, its biggest one-day decline since 2007. Chinese stocks are now some 50% below their June peak. Thousands of stocks have hit the limit of one-day declines of 10% and had trading suspended. Excitable news commentaries soon blew this up into a general panic that hit all world stockmarkets.
In fact, the China story is not the key to where economies and markets go next. The major developed markets either have growth momentum (the US and UK), or QE that looks as if it is starting to generate momentum (Europe and Japan). These economies (Germany is the possible exception) are not highly dependent on trade with China and the major growth that is happening is in services rather than manufactured goods. So while China and emerging economy slowdowns will reduce world GDP growth, perhaps to 3.3% in 2015, growth in developed markets overall is more likely to accelerate than decline. The low rate of core inflation in developed markets (averaging 1%) gives central banks an excuse to delay interest rate rises still further. Oil at under $50 per barrel and lower commodity prices mean headline inflation rates will probably trend down until well into Q1 2016.
The global macroeconomic background is therefore quite positive and neither macroeconomic nor monetary indicators signal an end of the bull trend. Some analysts say everyone still has far too much debt and this will act as a progressively worse drag. But much of this debt is accounting fiction. For example, how much of the government debt held by central banks can be said to still actually exist? And if an interest rate rise of about 1%, and hence the discount rate used to value liabilities, would eliminate all the pension deficits of the FTSE 100 companies, how real are those supposedly vast pension deficits?
The challenge for China
The transition from an investment-led to a consumer-led economy was always going to be a huge challenge for China. It has achieved as much of a consumer boom as anyone could expect – wages continue to rise at 10-15% and so does consumer spending. The only problem is that investment has declined even faster – as it had to – and the process of making massive state-owned businesses more efficient is a work of years rather than months. I suspect that if the Chinese authorities had got a large placing of shares in one of the SOEs away in Spring 2015, they would have slowed the market enough to prevent the summer sell-off. As it is, with only 6% of Chinese actually owning shares, and virtually no institutional investors in the market, the market in local shares is like nothing anyone alive today has ever seen, though if you could channel the ghosts of late 19th century US investors you might get close. To be fair, the authorities are rushing to introduce regulation to the wild east of China’s markets, and are probably ahead of where the US was at this stage of its history, for example in restricting trading on margin, where the US only introduced serious restraints after the 1929 crash. But as history proves, nothing can restrain the madness of crowds.
Performance of Chinese stocks and Fidelity China Special Situations
The divergence in performance and rating within China is vastly greater than most people assume. For example, according to fund managers Hermes, recently the average prospective PER on the Hang Seng China Enterprises Index, consisting of large HK listed companies, was 8, as compared with a figure of 70 for the ChiNext index of high-tech start-ups. The Shanghai Composite, with 1,100 companies, had an average PER of 15 while the larger Shenzen market (1,700 companies) had a ratio of 30. Fund managers tell me they continue to find good businesses to buy on very undemanding ratings.
The Chinese authorities’ reactions to the panic have been inconsistent. They banned large investors from selling stakes and effectively stopped short selling, then deployed a sum of between $150bn and $200bn to “market stabilisation” purchases, which has predictably been ineffective. On the other hand, they are improving brokerage and market regulation. They have cut interest rates and also bank reserve requirements, providing a monetary boost, and analysts expect a supplementary fiscal boost shortly. Most analysts expect the Chinese to avoid a meltdown or a “hard landing”: GDP growth this year may end up nearer 5% than 7%, but if it is inefficient and unproductive investment that is being subtracted from GDP, the effect will probably be smaller than most people think.
JPMorgan’s data confirms the valuation opportunity: their composite figures as at end-June showed China trading on a prospective PER of 10.6 as compared with a 10-year average of 11.8, and a price to book ratio of 1.2 versus a 10-year average of 2.1. Those figures will be at least 20% lower now. Its data also shows emerging markets as a whole at well below their historic average valuations.
Meanwhile, most fund managers have cut emerging market equity holdings and are underweight or heavily underweight the entire asset class. So it is at least arguable that we are being offered a once-in-a-decade opportunity to buy into an asset class at bargain levels.
If you go along with this, then you need to decide whether to buy a global emerging markets fund and leave the managers to decide how much to allocate to China, or pick a dedicated China fund and endure greater volatility. Or, as I have done, do both. I have selected three emerging market funds, all with highly regarded managers and better than average performance records. Somerset’s Edward Lam is very long-termist and with EM dividend-generating stocks at a discount to their long-term averages you could view this fund as offering a double discount. Its lower Asian allocation means it will likely be less volatile than the others. Fidelity and Hermes are both active asset allocators. Both managers are positive on China and Asia – we have yet to see any manager allowing themselves to express a bullish view on Brazil or Russia, both of which now have pariah status in the investment community – and both say there are plenty of good businesses whose shares they can buy at sensible prices. My own recent choice of these funds has been Hermes.
Emerging market funds’ performance
For a pure China exposure, I am sticking with Fidelity China Special Situations investment trust. Its level of gearing at 29% has pulled it down but will also propel it up when the market turns. Add that to a current discount to NAV of 15% and there is scope for sizeable and rapid gains. I have recently added to my holding and may well do so again.
Chris Gilchrist, September 2015