China Equity Market Not Expensive If Real Growth Slows Some

We recently increased our Developing Markets exposure slightly -- via Chinese ADRs -- given signs of the world financial system "muddling through" the crisis period. A "muddle through" is the bull case, and the more we muddle, the lower the chance of the "tail risk" of a major melt-down.

We're still underweight equities overall, and Developing Markets equities specifically, because we don't think we're at "the beginning of the end" of the financial crisis yet. (One thing we're waiting for is a Developing Market financial crisis as a sign that the global crisis has come full circle.)

Nevertheless, a bump-up in our Developing Market allocation via China has a somewhat higher reward/risk ratio than it has for a while, we think. A few helpful tidbits today in an FT Opinion article from Jake Lynch of Macquarie:

• A recent survey of Chinese A-share investors found that 70 per cent believed they were investing in a bubble, matching the perception of most foreign observers.

  The A-share market has been cited, according to a standard calculation, as trading at a price/earning ratios of 70 times. Even worse, 30 per cent of earnings are alleged to come from investment income (that is, stock trading) - in effect, a giant Ponzi [pyramid] scheme.

  Combine the above with a reputation for questionable accounting practices, as well as the threat of $1,300bn of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-share market is now off about 36 per cent from its highs.

  So is this correction just the first leg of the great unwinding? Not likely.

  In fact, it is hard to find evidence of a bubble at all. Take valuations: the benchmark CSI 300 index is now trading at 23 times 2008 consensus earnings forecasts. This is not cheap, but it is far from what we think of as bubble valuations and below its 10 year average of 30 times. How did we get from a multiple of 70 to 23 with a 25 per cent share price correction? First, bearish commentators were focusing on the smaller but more expensive Shenzhen market and looking backwards 12 months. Second, earnings grew 48 per cent in 2007 and the consensus forecast is for 32 per cent earnings growth this year.

  While 32 per cent seems like an aggressive number given the global slowdown, 7 percentage points come from a one-off tax break and a 25 per cent pre-tax growth rate may be achievable with a mid-teens nominal GDP growth rate - particularly when banks, oil and commodities are the main drivers.

  And what of all that investment income (which would presumably be turning into losses about now)? In fact, the 30 per cent figure was and is misleading as "investment income" contains all operating income from joint ventures and associates. Stripping those out, we found that only 9 per cent of non-financials income was generated by some form of asset revaluation.

  How much can we trust these numbers? More than 70 per cent of the CSI 300 market cap is now audited by the Big Four accounting firms using IFRS: the risk of accounting misadventures is now no higher than other emerging markets.

  The final issue supposedly dooming the A-share market is the unlocking of the non-tradable shares and the threat that the current holders of such shares will flood the market.

  Yet a quick glance at the A shares that have been unlocked since 2006 shows that only 10 per cent were actually sold into the market In fact, more than 75 per cent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives - that it will control the issuance of supply to continue to foster a healthily developing market.

  Indeed, the increase of share supply is critical for a sustainable market. A shares have historically traded at high valuations because China's ratio of free-float market capitalisation to both GDP and savings remains far below other emerging and developed countries.

  In other words, there is not enough "supply" of shares relative to high "demand" from savers (especially given today's negative real interest rates). Both supply of and demand for shares are likely to rise rapidly in coming years, inevitably resulting in high volatility.

  Does any of this matter for international investors? With 72 per cent of the market cap of the MSCI China already dual-listed in Hong Kong and Shanghai (and the percentages rising monthly) the answer is yes. Hong Kong investors closely watch the price movements of the listed A shares and the recent correction in the A-share market has been an important cause of the MSCI China's underperformance relative to other emerging markets.

  While the A-share market may not yet be at a bottom, it can't be characterised as a bubble that is bursting.