By Nial Gooding*
Buy low, sell high. Easy to say but hard, in the real world, to do. What if we sell high and things go higher? What if we buy low and things go lower? On the downside, though there comes a point where, if assets are real, companies are going concerns and profitability is intact, you have to shut your eyes and dive in. This is the situation with Chinese stocks at present.
Before addressing obvious concerns let me digress on the subject of valuation. In aggregate, China stocks have never been cheaper. In fairness, many of these companies don’t have a 50-year track record (as a reminder, modern-day China has only had an exchange since 1990) so a discussion of what ‘fair value’ may be is hard. The fact remains, though, the P/E and book values of the main China indices have never been lower. Presently, the Hang Seng China Enterprises Index of mainland firms traded in Hong Kong has a forward P/E of 6.4x and an implied price-to-book ratio of 0.94. Moreover, this is at the same time as earnings are likely to complete a fifth straight year of improvement and, presently at an all-time high, will likely move to fresh highs in the coming year.
To return to my main point, in aggregate China stocks are backed by real assets, are most definitely going concerns and have manifest and rising earnings. So why aren’t investors taking the plunge?
In addition to the global wilt that has characterized all emerging markets this year (China, by the way, is neither Turkey nor Argentina) there are particular issues with China that investors have problems with. The financial system is believed to be rickety, top-line economic growth is being managed down, numbers can’t be trusted and there’s a general feeling that something’s just not quite right in China.
I can’t tell you with authority that these fears are misplaced. China uses the same highly volatile fractional reserve banking system that regularly fails elsewhere in the world and at some point it’ll be stressed there too. True, also, the new administration has said clearly that quality, not quantity, of economic growth will in future be a policy target.
Numbers in any economy are often subject to years of revision but China is just so much bigger than most other places; but yes, sometimes local officials do try to nudge the needle and finally, yes, it’s still a partly opaque window that we peer through into China and investors can’t be blamed for being afraid of the dark.
The bottom line, though, is that present valuations incorporate more bad news than at any time in the past and, therefore, unless there really is a vast hole that cool-headed analysis just can’t find, it’s time to close your eyes, do the hard thing, and start buying.
If you accept that, what do you buy? The answer can’t be ‘one size fits all’, so you must decide how you like your risk. I would advise against using Exchange Traded Funds. The problem is that the China market is what Charlie Munger, vice chair of Berkshire Hathaway, has called (not referring to China) ‘a turds and raisins proposition’. That is: if you mix the two you have a very unappetizing dish despite half being edible.
China has listed some great companies and there are trustworthy entrepreneurs that we are presently invested with. But it has also listed some fat lemons that affect the performance of the main indices that most ETFs will be based on. Sure, if there’s going to be big rip your ETF will do fine but be clear that that strategy has more to do with gambling than process-driven investing.
*Nial Gooding is senior analyst, China, for APAC specialist fund manager Eight Investment Partners.