China’s domestic Shanghai Composite Index dipped below 2,000 last month, down more than 55% in 5 years *. This contrasts starkly against the country’s widely accredited success in navigating the global financial crisis of 2008 and a GDP growth rate that is still angling close to 8% this year. Worryingly to some the index has continued its slide in the past month despite signs of growth stabilising.
Clearly, the domestic market was expensive when it traded at 20x earnings and 3.3x book value as recently as 2009. The unrestricted, thus arguably more “rational”, HSCEI index of Chinese shares listed in Hong Kong was priced at 16x earnings and 2.4x book value at that time and has subsequently fared better. The high multiples previously seen for A-shares were partly a result of limited investment options for the average citizen and market participation by state-owned enterprises (SOEs) with idle cash balances **. The latter has diminished somewhat following increased state-asset supervision and a tighter liquidity environment since. Meanwhile, China’s GDP growth has receded from a high of 11% in 2007 and concerns over the country’s financial companies, which make up 37% of the Shanghai Composite, have undermined index performance.
Technical factors have also played a role. Statistics from the China Securities Regulatory Commission (CSRC) show that Rmb286bn (NZ$56bn) was raised from the domestic equity market through the first 10 months this year, after having extracted Rmb895bn in 2010 and Rmb507bn in 2011. In addition, domestic bond issuances have picked up and reached Rmb183bn to October, diverting funds away from the stock market.
But with the Shanghai Composite now trading at 10x earnings, new stock issues are abating and valuations are relatively low for the region. Skeptics of the China story cite weaker corporate governance and inefficient use of capital as some of the reasons for a valuation discount.
We agree with the emerging market risks but we do not think China is necessarily doing worse than, say, India or Indonesia. Rather, we think liquidity condition is a more likely short term factor, a situation that will improve in January as banks get fresh lending quotas. Also, retail investors, a significant force in this market, have had an unpleasant ride on the local bourse and will move in and out of the market based on price momentum. Since the market has been falling, we think it fair to assume that this group has shrunk its participation, which can be a positive contrarian indicator.
If there is one thing to take away from this is that high GDP growth rates are no guarantee of investment gains. The realisation of growth in excess of expectation is a more meaningful concept. For shares in China, there is a clear short term window to rebound as expectations have been managed lower and the new leadership has every incentive to sustain growth for a while. Longer term, growth will slow but the valuation discount may also narrow if market friendly reforms come through.
*The Shanghai Composite Index consists of domestically listed shares which are traded between Chinese nationals and certain qualified foreign institutions (QFIIs). Some of these overseas institutions have formed listed funds to offer foreign investors exposure to the domestic market.
**A-shares refer to shares of Chinese companies listed domestically and quoted in Renminbi (Rmb) or Yuan, the domestic currency. H-shares, which form the HSCEI Index, are shares in mainland incorporated companies listed in Hong Kong and are freely tradable by international investors.
Felix Fok
Senior Analyst