Investors Risk Fall Into China Value Trap

Robert Cookson
A lone Chinese investor talks on the phone as he monitors his stock prices at a security firm in Hefei, east China's Anhui province.
AFP | Getty Images

Foreign investors face a big dilemma when it comes to China.

On the one hand, Chinese equities appear cheap. Valuations have fallen close to the lowest levels in a decade relative to corporate earnings and book value. By these measures, stocks are a screaming buy.

On the other, the Chinese economy is slowing sharply. Profits are falling, bad debts are mounting, and investors have woken up to the reality that China cannot grow forever at a smooth rate of more than 8 percent.

The question is whether investors who buy Chinese equities now are visionaries or are falling into a classic “value trap”.

Fraser Howie, co-author of Red Capitalism, urges caution. He says that while people have wised up to many of the risks of investing in China in recent years, many are still too bullish and “there’s still a lot of wishful thinking”.

One of the most dangerous misconceptions still prevalent, he says, is the idea that the Chinese government is “all powerful – that they somehow are better stewards of the economy than in the west”.

That belief came to the fore after the 2008-2009 global financial crisis. While the US and Europe stagnated, China’s economy bounced back quickly and attracted large amounts of foreign investment in the process.

Only recently have many investors realized that the main reason for China’s resilience – a huge government-directed lending and spending spree – cannot and will not continue, at least not without further distorting the economy and risking a bigger crash in future.

Ray Dalio, founder of the world’s largest hedge fund Bridgewater, reckons China’s growth ratewill soon fall to 4 or 5 percent – much less than Beijing’s target of 7.5 percent and the expectations of most investors.

“China was in a bubble and their bubble’s bursting,” the $130 billion hedge fund boss told an audience last week at the Council on Foreign Relations in New York.

“They have a domestic demand problem that’s emerging, they have an export problem ... and they have an efficiency problem in terms of allocating capital,” he said.

The relentless decline of China’s domestic stock market during the past four years baffled many foreigners but is one of the most obvious signs that all is not well in the world’s second-largest economy.

“Just as the S&P 500 is a barometer of the social mood in the US, the Shanghai Composite is in China,” says Nicholas Ferres of Eastspring Investments, one of Asia’s largest asset managers.

“It is telling that the index has failed to rally following the recent announcements on additional infrastructure spending and policy easing,” he added.

Like their domestic counterparts, Chinese stocks listed on global exchanges from Hong Kong to New York have also performed poorly and fallen to levels that are traditionally seen as “cheap”.

Part of the problem has been allegations of fraud at private sector companies such as Sino-Forest, but the bigger issue is the declining profitability of corporate China in general, including the enormous state-owned enterprises.

The MSCI China index , a global benchmark, is now trading on a forward price-to-earnings multiple of about nine – not far from its all-time lows. By contrast, the S&P 500 index trades on a forward price/earnings multiple of 14.

Valuations have also tumbled in terms of book values. H shares (mainland Chinese companies listed in Hong Kong) are now trading on a price-to-book multiple of 1.3, down from more than four times in 2007. China’s vast state-owned banks have fared particularly badly, as investors are bracing for big writedowns in the value of loans on their balance sheets.

Traders say the substantial increase in pessimism about China during the past few months may have opened up a short-term, tactical opportunity for contrarian investors to buy Chinese stocks.

But Mr. Ferres of Eastspring says there are structural reasons to be cautious about Chinese equities in the medium term, as measures of profitability have declined markedly in recent years while leverage has increased.

“We worry that this reflects over-investment and misallocation of capital in some sectors of the economy,” he says.

Worse, many of the factors that powered the growth of the Chinese economy over the past decade are now diminishing: its currency, the renminbi, is no longer seen as undervalued; population growth has slowed; and investment growth, which now accounts for 50 per cent of gross domestic product, appears to have reached its limits.

What is clear is that investors have woken up to the realities of China. The old myth of unstoppable, rapid growth is dead. Unfortunately for investors, the new narrative is much less certain.