Fears of a Chinese equities bubble are overdone because the role of the domestic consumer and improving transparency of earnings have been underestimated, says Martin Lau, director of Greater China equities at First State.
He says many investors are also too focused on the pure-play option, without acknowledging the links between Taiwan, Hong Kong and China, which mean the latter can be played more efficiently through proxies – albeit not all the time.
"The bubble theory is based on concerns over GDP growth figures, on the 70% growth in the number of cars sold last year, or on the rise in the stockmarket," Lau says.
"But this ignores the impact of the person."
Lau believes the investor focus on China’s manufacturing capabilities is set to be usurped by big increases in domestic consumer spending in China, by those who on average have been tucking away 42% of their annual salary in the past 10 years.
"In the next 10 years, people will start spending," he says.
"The middle classes are already 300 million strong and growing by about 30 million per year. GDP may be growing at 10% annually, but per capita GDP is still just 3% of the UK’s and there are currently just 2 credit cards for every hundred people in China, compared to 2.6 for every single person in the UK."
Because of the shift in spending patterns, sectors such as tourism and retailing could see strong gains over the next decade. One example is Hong Kong-based retailers that are actually making more profits from some stores in China, despite the lower average incomes there.
Short-term investor issues exist, of course, such as the current strong commodities cycle and the way China is perceived to be driving prices of metals such as copper to record highs.
True, steel prices are rising, but in China steel output rose by 100% last year, and the longer higher commodities prices continue the greater the probability they could fall, meaning commodities prices are more uncertain.
Another issue is currency, with strong pressure by the Americans for an appreciation of the Reminb. Exports branded "made in People’s Republic of China" (PRC) now account for about 11% of all imports to the US. However, political noises are unlikely to succeed simply because the Chinese leadership will merely dig its heels in deeper in response to what it sees as outside interference in the economy.
It is more likely that economic forces will lead to such a currency appreciation. A stronger currency would make input prices cheaper for manufacturers and spur domestic demand for imports, both of which would contribute to broadening and deepening the economy, Lau says.
Another factor in the currency issue is China’s huge foreign currency reserves generated by its exports. Many manufacturing companies based in the People’s Republic are running big current account surpluses. This capital has to go somewhere.
It is not inconceivable that as the Chinese economy moves up the value change – by, for example, manufacturing goods with more intellectual property value rather than socks and shoes – Chinese companies will seek to make investments abroad, somewhat similar to the pattern followed by Japanese and Korean companies in the 1980s and 1990s, Lau says.
A big change this year is expectations of another round of initial public offerings by the Chinese state, which still owns most big companies in the country. Lau expects some 70 IPOs.
This could create some overhang issues for investors, he says, but the alternative view is it will result in greater choice of investments coupled with continued improvements in transparency and corporate governance.
The average current price/earnings ratio for Chinese stocks at 14x is below 18x for the rest of Asia and well below the 30x multiple of the US market. This reflects the discounts applied to earnings figures released by Chinese firms because of the currency issue, but also because of political issues such as government ownership of companies and sabre-rattling involving Taiwan.
This discount should narrow over time, Lau says. There is growing evidence of the reliability of earnings figures, for example, in the shape of dividend payments. Many firms are paying dividends equal to 40% to 50% of reported earnings, which would be extremely difficult if those earnings figures were unreliable.
A multiple of 14x would traditionally be seen as a sell signal compared to a range of between 7x to 10x at which many traders feel more comfortable when dealing with Chinese stocks, Lau adds. However, these prices are supportable if investors are careful in their stockpicking and track the earnings growth story, rather than relying on the market pushing prices higher or lower.IFAonline
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