CHINA: A VALUE TRAP?

The Chinese market is cheap, no doubt about that as this J.P. Morgan chart demonstrates. Other than Russia, where one needs a lot more than luck, China is currently THE cheap equity market in the world.

Here’s the bullish case:

• Investing in China: Time to be bold (FT Lex)

Go on, be bold. Buy China. If there can be a consensus contrarian bet, it is increasingly Chinese stocks. (…)

China stockpicking comes with caveats such as assuming the whole country is not about to collapse under a mountain of bad debt. But such consensus predictions of widespread utter disaster rarely work out as forecast. As in the eurozone before 2012, outsiders can underestimate political will to do what it takes to avert disaster. In China in 2014, that means buying once it is clear policy makers know what they are doing with the financial system. The country’s stocks are certainly beaten down, however. Take the Hang Seng China Enterprises Index as a proxy, since mainland investing is so restricted. It is trading on seven times forecast earnings, compared with 16 and 14 for the S&P 500 and the FTSE Eurofirst respectively. Another Asian emerging market, Jakarta, trades on 15 times. Chinese stocks in general offer their biggest discount to each in at least five years.

The 40-strong HSCEI comprises mainland-incorporated companies’ Hong Kong shares, ranging from Air China to Zijin Mining via the usual names such as the big banks and the likes of PetroChina and Great Wall Motor. Put the banks aside for now: time enough to look at them when a likely wave of preferred issuance has passed.

In bargain-hunting terms the most beaten-down stocks, as measured by the change in their forward p/e ratios, include power generators, machinery makers and infrastructure builders. Spot the slowing economy fears with a dose of worry about overcapacity.

But dig a little deeper, and power generators, for one, could be worth a look. Huaneng Power’s forward p/e has fallen a quarter to eight in a year, yet its cash flow, relative to sales, has risen more than 50 per cent. China Longyuan, its windpower rival, has a p/e of 14 and lifted its cash conversion rate 80 per cent. Cheap does not mean bargain. Huaneng’s coal-based stations face environmental issues, too. But if a more upbeat mood continues bargain-seeking could become as fashionable as China-bashing has been.

• Why Chinese Stocks May Still Make Sense Over the Long Run (BlackRock Investments)

(…) The MSCI China, for instance, is trading at a price-to-book ratio of 1.4, representing a 25% discount to the 5-year historical average and a 47% discount to U.S. equities, while broader EM markets are trading 16% below their historical average.

China is making progress on much needed financial system reforms. Concerns about currency depreciation and corporate defaults have been overshadowing evidence that China is moving toward achieving necessary structural reforms and that there’s likely to be a quicker timetable for key reforms than many market watchers currently expect. In March, for instance, China announced a widening of its currency band, the range within which the local currency can float. Meanwhile, the country’s central bank recently suggested that it will relax control on a number of bank deposit and fixed-income product interest rates within the next one to two years.

The Chinese government is unlikely to abandon their growth objectives. The government’s recent pledge of more stabilizing measures almost immediately following news of disappointing growth data indicates that China will prioritize achieving stable economic growth while gradually pushing ahead with much-needed reform. Meanwhile, the slowing of the Chinese economy is at least partly intentional on the part of the Chinese authorities, who want to transition the economy to one driven more by consumption than by investment, a transition that should be good news for the market. It’s also important to view China’s growth in context: China is still growing faster than other developed and emerging economies.

The Chinese market is potentially less vulnerable to tighter U.S. monetary policy. The Chinese currency and market are better positioned to withstand a rising-rate environment than many other emerging markets, given China’s current account surplus, ample foreign exchange reserve and low external debt.

Here’s why you should curb your enthusiasm:

To be sure, many of investors’ concerns are justified, and there are significant short-term risks for investors in Chinese stocks. These risks include the country’s unregulated shadow banking system and the risks associated with the inevitable slowing of credit growth. While an accurate estimate of the system’s size is difficult, even conservative estimates imply that it has more than doubled in size since 2008. In addition, one consequence of the China’s excess credit accumulation since 2008 is capital misallocation, or a diminishing economic impact from easy credit.

Meanwhile, headline defaults – although small and not systemic – from wealth management products and corporate bonds are signs that China needs to rein in credit growth before a possible bubble bursts. Finally, some of the reforms I mention above may be disruptive to markets in the near term, and like any value-driven investment call, my overweight to China may take a while to work.

But despite these short-term risks, I believe that Chinese stocks are worth sticking with over the longer term. You can read more about my country views in my latest Investment Directions monthly market outlook.

More contrarian views that you should read before plunging deep:

• WATSA ON CHINA
• CHINESE ROULETTE
• From John Mauldin’s recent Thoughts From The Frontline:

Since we published “China’s Minsky Moment?” two weeks ago, the official data flow – which shows admittedly soft but fundamentally sound production – continues to conflict with real-world indicators, which reveal some alarming declines in production, prices, and demand. For example, the official manufacturing Purchasing Manager’s Index (PMI) for March 2014 indicates that manufacturing expanded, while the more objective HSBC Markit PMI suggests an alarming contraction in manufacturing activity that is consistent with a rough landing.

With such an ambiguous picture, we cannot know for sure whether Chinese production is moving ahead or falling behind… but a Kookaburra in the regional economic coal mine is calling at the top of its lungs. The recent collapse in Australian new export orders and moderate contraction in Australian production could point toward a real man-eater lurking in the Chinese bamboo (now that’s what I call some real tall grass!).

The China bulls use history to show that when the economy gets weak enough, Beijing reacts forcefully. Hence the recent Pavlovian equity bounce. I am sceptical about the Chinese government’s ability and experience to steer this giant ship through these uncharted waters. I am not alone:

My impression here is that the government is in a catch 22: it remains committed to both reforms and 7%-7.5% growth, but it is impossible to achieve both for a substantial period of time; and yet it is not ready to give up on either of those two goals. The result? That China eases less than it needs to grow 7.5% and reforms less than it needs to eliminate the risk of a credit crisis a year down the road. Financial markets remain schizophrenically shifting between hard landing, soft landing and no landing at all.

So in the short term, as economic weakness spreads and deepens, the government will make some noises to try to stabilize the economy, I believe they will be quite small, but it will cause bears to stop pressing the short trade. Medium term I am quite skeptical about how sustainable any short term mini stimulus related economic acceleration will last. (Prince Street Capital Management)

Some Chinese may be appropriate in your current diet but don’t overuse the MSG…