All in the price in China?

April 4, 2012

It’s been a while since Chinese stocks earned investors fat profits. Last year the Shanghai market lost 22 percent and the compounded return on equity investments there since 1993 is minus 3 percent. This year too China has underwhelmed, rising less than 3 percent so far. Broader emerging equities on the other hand have just concluded their best first quarter since 1992, with gains of over 13 percent.

Given all that, bears remain a surprisingly rare breed in China. A Bank of America/Merrill Lynch’s monthly survey found it was fund managers’ biggest emerging markets overweight in March and that has been the case for some months now.  Clearly, hope dies last.

Driving many of these allocations is valuation. China’s equity market has always tended to trade at a premium to emerging markets but in recent months it has swung into a discount, trading at 9.2 times forward earnings or 10 percent below broader emerging markets.  MSCI’s China index is also trading almost 25 percent below its own long-term average, according to this graphic from my colleague Scott Barber (@scottybarber):

There are reasons for the cheapness of course. The economy is slowing and looks on track for its weakest quarter since 2009. Recent corporate earnings have disappointed and there are worries over local government debt and bad loans at banks.  The property sector remains a worry and it is unclear if the PBOC will ease monetary policy. But many reckon the problems are in the price.

JPMorgan Asset Management for instance has changed its historic bias against Chinese stocks in its EM fund. China is now the fund’s  biggest overweight, more than 5 percent above the MSCI benchmark. Client portfolio manager Emily Whiting expects the market to rebound strongly once investors start unwinding their doomsday bets:

Historically China has been an underweight for us as we always felt the valuations too rich against the broader emerging markets opportunity set.. Now it is our largest overweight country position, we feel the market has priced in too much bad news and it’s created buying opportunities…. it’s a great environment for stock pickers.

Morgan Stanley this week predicted MSCI’s China equity index to rise 22 percent in 2012. The bank reckons for one that the growth fears are overdone, upping its forecast for 2012 to 9 percent. And Jonathan Garner, MS head of emerging equity strategy argues the risks are well factored in — for banks for instance (23 percent of MSCI China)  a hypothetical worst case scenario would cause a 45 percent earnings drop from current levels. That would imply shares trading at a 12.3 times earnings on a trailing basis.  In fact they trade these days at 6.8 times. The  historical average is 16.2 times, Garner notes.

In short the current P/E level of Chinese banks has already factored in considerable downside earnings risk.

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