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It was a dire January for Chinese stocks. After falling almost 10 per cent, Hong Kong’s Hang Seng stock index now trades around the same levels it did in 1997, when Tencent and Alibaba, two of its largest constituents, had not yet been founded and the territory had just returned to Chinese sovereignty.
At a recent conference in the city, more than 40 per cent of participants declared Chinese equities to be “uninvestable”. Strategists complain that fund managers have stopped listening, while frustrated mainland investors have taken to grumbling on the US embassy’s social media accounts, where they have some hope of evading censorship.
A generation of missing returns, market exhaustion and the magic word “uninvestable” — it sounds like an opportunity. A value trade requires enough gloom to drive market prices below intrinsic value and China’s market is not lacking for pessimism. The question is whether this is a value trade or a value trap. For it to be the former, two things need to happen.
First, the companies themselves must act as what they currently are: an unfashionable discount product that needs to sell itself on tangible results, rather than airy promises of future growth. Specifically, Chinese companies will need to rebuild investor confidence by returning cash with buybacks and dividends.
Second, Chinese domestic investors must regain trust in the market. Foreign buyers might ride a recovery. They cannot drive it.
On valuation alone, there can be little doubt — Chinese stocks are some of the most attractive assets available in global markets. According to Deutsche Bank, the Hang Seng index trades at a forward price-to-earnings multiple of about eight, ie you pay $8 for around $1 of annual earnings, which compares with global equity valuations of more than double that. Its price-to-book value is less than one.
Nor are these failing companies. The largest, such as Tencent and Alibaba, are highly liquid and still growing. They are trading on forward price-to-earnings multiples of eight to 13 times, with healthy free cash flow yields, indicating they generate ample flows of cash after covering their investment needs. If these companies reverted to trading in line with their US peers, investors would comfortably double their money overnight.
The cause of these low valuations comes in two parts. First, there are factors that have damaged investor confidence in the future profitability of Chinese companies: the weak economic recovery, which hampers revenue and profit growth in the short term, and Beijing’s regulatory crackdowns, which reset perceptions of profit potential in many sectors. To the extent that their investment opportunities have diminished, companies operating in these sectors should return cash to investors instead, and in some sense they are doing so. Both Tencent and Alibaba paid dividends and repurchased shares last year.
Beijing is slowly easing up. It will provide more fiscal support for the economy this year and has set more explicit rules in areas such as online gaming. Fundamentally, China’s economy still has a lot of room to grow, and that should be good for corporate earnings.
The more difficult issue is geopolitics. Geopolitics, in most cases, has no direct effect on corporate profits: tensions over Taiwan do not stop players of Tencent’s online games or shoppers on Alibaba’s Taobao mall. Rather, it creates a hard-to-estimate risk that, at some future date, international investors will arbitrarily lose access to their stream of earnings. This is what happened to foreign investors in Russia when it invaded Ukraine. Quite naturally, investors will pay less for a stream of earnings that might suddenly evaporate.
At present, the removal of this discount via a reduction in geopolitical tension is implausible. However, the discount will be especially severe when a company retains its earnings for internal investment, in which case all the potential cash flows to investors belong to the distant, uncertain future. By delivering buybacks and dividends, Chinese companies can make those cash flows more immediate, more certain and therefore more valuable.
But geopolitical risk still creates an unavoidable wedge between the value of a Chinese stock to an international investor — who runs the risk of appropriation — and a domestic investor who does not. A recovery will only come when domestic investors regain their appetite for a stock market that has treated them badly in the past.
Signs of official intervention caused stocks to rise a little on Tuesday, but state-backed buying by the “national team” will not produce a sustained recovery. More promising is a decision by the body in charge of state-owned companies to start evaluating managers based on the stock performance of their listed units, while the securities regulator is pushing for dividends, buybacks, mergers and swifter delisting discipline over issuers that misbehave.
Chinese investors rightly question whether the market will be run in their interest, but with the housing sector unlikely to recover any time soon and capital controls as tight as ever, they lack other places to park their money.
A Chinese market revival based on returning cash to investors would be painful medicine for a set of companies that a decade ago seemed set to conquer the world, but it would bring the value trade to fruition — giving foreign investors a final chance to cash out.