29th July 2015
Kevin Murphy fund manager and contributor to the Value Perspective looks at China from the perspective of value investing.
Sizing up whether or not a particular business will make a suitable value investment can often be a time-consuming and labour-intensive process. Here on The Value Perspective, however, any decision on whether or not to invest in China over the last 18 months or so is unlikely to have detained us for more than a couple of seconds.
Some of the statistics suggesting the Chinese equity market was – and remains – overvalued are jaw-dropping but let’s content ourselves with the Bloomberg analysis that recently showed the average technology stock in China stood on a price/earnings ratio that was 41% higher than, and a median valuation that was twice as expensive as, its US counterpart in 2000.
With the benefit of hindsight, people now see 2000 was a market bubble – indeed some insightful souls saw it at the time – so clearly China is horribly expensive. Here on The Value Perspective, that in itself is enough to have us looking elsewhere and yet, to our continual surprise, not everyone invests on a value basis. So are there any other ‘red flags’ to which we could helpfully draw investors’ attention?
You bet there are – and we will start off with the huge price discrepancies between Chinese companies’ ‘H-shares’, which may be traded by international investors, and their ‘A-share’ equivalents, which are only open to local investors. Remember, these are the same businesses doing the same things but the A-shares are trading at twice the price international financial markets are willing to pay.
So that ought to be a concern – as should further Bloomberg data showing that, while the overall Chinese market may look expensive, some 94% of Shanghai Composite stocks are trading at higher valuations due to the index’s heavy weighting toward China’s lowly-valued banks. This alarming skew suggests headline metrics are not necessarily telling investors everything they need to know.
Then there is the huge level of margin debt we discussed in Crash course. Until recently, China had no rules on how much investors could borrow from their broker to buy shares – and indeed there is a line of thought that the authorities’ plans to address this may have provoked the crash. Worryingly, margin borrowing has now exceeded $320bn (£205bn) or 10% of the total market, according to The Guardian.
Our next concerning statistic comes from The Wall Street Journal. Apparently some Chinese manufacturing companies have completely shut down their main operations so they can concentrate on stock-trading – with 97% of the growth in manufacturers’ profits now generated in this way. Remember all the people who gave up their jobs in the tech bubble to become ‘day-traders’ and how well that did not turn out?
In case anyone out continues to think China might still be worth a punt, we have one last terrifying number – this time from the country’s Bank of Communications, which has noted the average holding period for stocks has fallen to just one week. Here on The Value Perspective, we realise our own average holding period of closer to five years makes us unusual – but really? Seven days?
This is taking “irrational exuberance” to a whole new level and yet, rather than attempting to put a brake on things as the originator of that phrase, former US Federal Reserve chairman Alan Greenspan, at least attempted to do in the late 1990s, the Chinese authorities have at times appeared to be doing the polar opposite.
When the Shanghai index reached a high of 4,000 back in April, for example, People’s Daily – described by Wikipedia as “an official newspaper of the Chinese Communist Party” – reflected: “What’s a bubble? Tulips and bitcoins are bubbles … But if A-shares are seen as the bearer of the Chinese dream, then they contain massive investment opportunities.”
Again, that makes us very nervous – though perhaps not so nervous as China’s powers that be. When markets are rising and everybody is growing rich, it can be seen as a ringing endorsement of the ruling Chinese Communist Party and its policies. When markets are falling, people begin to take the opposite view – and the opposite view is not renowned for going down well in China.