China equity boom: on your marks
China’s reforms should generate a boom in its equity markets, says Michael Chiu, equities investment director for Asia Pacific at HSBC Global Asset Management. And the trend may have already begun.
He delivered a robust argument for active stock picking in Chinese equities at AsianInvestor’s Southeast Asia institutional investment forum in Singapore this week.
Any China equity fund manager is going to say rosy things about his or her own book. Chiu’s claims rest on reforms being successfully implemented. That, in turn, will depend on the ability of the central government to convince influential local governments and various ministries and other fiefdoms to cooperate.
For example, Chiu notes that 25% of China’s steel production comes from Hubei province, where officials have been rewarded primarily for achieving GDP growth targets – at the expense of efficient capital allocation or the environment. Although there are clear benefits at the national level to changing this picture, it will mean lost jobs, an end to spinning rural land into cheap urbanisation projects, and so on. The local governments have also become highly indebted and will resist efforts from the centre to absorb new liabilities.
Given encouraging signs, however, it appears the Xi Jinping administration is prepared to knock heads, if required. So reforms around price liberalisation as well as other reforms that can shape urbanisation and social trends – such as ending the one-child policy – could have a powerful rejuvenating effect.
Although the Xi administration has shied away from privatisation – the fastest, most efficient route to shifting wealth from the state to households – it does recognise the need to restructure the state-owned sector. Price reform is one tool, taking away ultra-cheap capital. Margins on SOEs have declined over the past decade from an average of 14% to below 1%, says Chiu, while leverage has swollen.
Some of this is because SOEs get called upon to perform ‘national service’, non-commercial projects. This will need to end if SOEs (and by implication, the state-owned banks that lend to them) are to be put on a firmer footing. Doing so could underpin a new, multi-decade boom in equities, such as the country enjoyed thanks to the Zhu Rongji-inspired reforms of the mid-1990s.
The A-share market index today languishes around 2,400 points, still well below the 6,000 mark it reached in the early 2000s. Chiu notes, however, that in US dollar terms, the value of the market capitalisation of China’s Shanghai bourse is now almost the same as its peak in 2005. Market cap is simply price times volume; prices sure haven’t gone up, but issuance has – at least until 2012 when the authorities put new IPOs on hold, with a view to improving the quality of new issuance.
Now that pipeline is set to open again, but with new rules. For example, the concept of underwriting has been updated so that investment banks must actually assume real risk. They will be required to swallow any IPO shares that don’t get placed at the market price.
Previously, crazy valuations were set because of a lack of liquidity (often due to miserly free floats) which allowed companies and their bankers to dictate a price. That explained lousy companies trading at 40x or 50x forward earnings. The new framework being deployed by the securities regulator will hopefully mean proper practices and market risks for participants, which in turn means the divergence between the value of the A-share index and the value of its market cap will close – or at least both will rise.
Another measure, less formal but widely expected, is that the government will demand higher dividends from SOEs. The average state-owned company dividend today is around 4%, which is not bad for minority shareholders. But there are rumours that companies must begin to pay back much higher dividends, which means paying out of cash earnings: and that will squeeze managers’ ability to resort to accounting gimmicks. Minority shareholders should benefit as well, says Chiu.
For foreign investors, access to A shares will continue to be limited. But it is improving. Just in 2013, the total quota allowed to qualified foreign institutional investors (QFIIs) rose from $80 billion to $150 billion, and over the past year senior regulators have mooted the idea of expanding this dramatically.
A fully open capital account would allow China to join global stock indices. Today it would account for 14% of the MSCI Global Emerging Markets Index, and 2% of MSCI World. While China is unlikely to throw open the doors like that, it is making efforts to draw in foreign investors.
The influence of foreigners on the workings of the A-share market is probably limited, but the ability to operate freely there would have a huge benefit to China portfolio managers. It means adding over 2,000 stocks to what’s available in Hong Kong, including sectors not well represented offshore, such as healthcare, IT and materials.
Although many investors wax lyrical about China’s consumer sector, Chiu notes that it contains a mix of extremely good companies and truly awful ones; and they are priced that way. So there is not so much room for value investors there.
However, Chiu cites other areas where he believes stock-pickers can bring something to the table, such as automobiles and oil services, and even property, where some companies may be too cheap now.
His biggest focus, however, is renewables, including nuclear, as well as solar, wind and hydropower. Many of these companies have been growing over the years at compound rates. Nor is it a simple tale of buying alternative energy. China remains glued to coal and vulnerable to oil price shocks. So the interesting area is in how it develops coal-to-gas and coal-to-chemicals projects, and the potential of tapping its enormous shale gas reserves.
More broadly, Chiu says that as the US central bank begins to limit the liquidity that has underpinned global equity markets, China’s defensive stocks will not perform as well. Similarly its traditional growth stocks are vulnerable to the domestic reform process (and haven’t been growing in any case). Cyclicals, however, have been quietly performing well, Chiu says. Pointing to this segment, he says, “It’s like the next bull market has already begun but no one has noticed it yet.”