Marco Polo's Aaron Boesky calls a China market floor

The Shanghai index has fallen more than 30% since its recent peak in August last year. Enough already, says Aaron Boesky, chief executive of Marco Polo Pure Investments in Hong Kong, who has made what he claims to be his most high-conviction call ever that this is a market bottom.

So, Aaron Boesky, what are you calling?
We're calling a bottom in July 2010, and think we're accurate on this call. The reasons being that Shanghai is near the lowest valuation level in history and at the same time is seeing very strong fundamental strength both in profits and in the general economy. It has wrongfully been punished and has been the worst-performing market in the world this year, ex-Greece.

Price/earnings ratios have come down from 72 in 2007 to 12 in 2010. That is close to 20-year lows. With profits estimated up at 25% growth for 2010 and an estimate of 30% here at Marco Polo for 2011, this market is due for a huge rebound.  

Last year's peak wasn't a bull market, but an upward correction in a bear market. We think the market is now transiting out of a bear market in the third quarter of the year and into a bull market that may last a year or more.

Explain the 32% market fall then.
The market has historically moved six months ahead of earnings, and has been fairly accurate in predicting the direction of earnings growth acceleration. The market had taken off in the first half of 2009 because earnings-growth acceleration had resumed dramatically from the second half of 2009, and forecasts for 2010 first half were huge. First-half 2010 earnings indeed came through and were up 50% year on year, but stocks in the first half of 2010 fell because anticipated earnings growth decelerated to 15% for the second half of this year. 

This market is witnessing fundamental trading patterns; it is not a volatile casino. As we see the market digest earnings-acceleration calls for the first half of 2011, we anticipate the market reaction will be a swift reversal, as usual for the Shanghai.  

We expect first-half 2011 profits growth will be more robust than second-half 2010 and back towards 30% earnings growth, and this visibility will start to wash into the market as early as August this summer. This and the extremely low valuations are why we're calling this the bottom. 

Further, one must take into account the state of today's Chinese economy. We are seeing very low unemployment, inflation less than 3.5%, healthy GDP growth, profit growth across the market and the credit cycle in China is likely to resume expansion due to new capital flowing into the banks and loose monetary policies founded on the low-inflation environment.

With 8% growth and 3% inflation, it's a win situation. Input prices such as oil and other commodities are very reasonably priced, and this will improve profit margins at many companies at the same time that revenues are picking up, as we see from an export increase of 48% in May year-over-year and retail sales increases of almost 20% in May year-over-year. There's nothing fundamentally wrong with this economy.

But statistics show deceleration in services and manufacturing.
[That represents] deceleration from artificially high numbers due to the amount of loans that went out during the crisis as GDP reached an unsustainable 12%. We are pleased to see the economy coming back in line with very healthy growth targets around 8% plus for GDP.  

Look, 25-30% earnings growth this year in the market and possibly 30% or more next year, and we will have a P/E valuation that has literally never been seen in this market. It's a screaming buy and money will come out of real estate and back into the stock market by the end of this summer in our view.

A lot has been said about high IPO issuance among the banks and a soaking-up of liquidity, with about $40 billion being raised. Our thesis is that this money raised by the banks will be re-lent after reserve ratios of 12% are satisfied.

With the benefit of [that figure] being magnified and levered up and being recirculated in the economy, we are looking at that same $40 billion raised by the Chinese banks translating into $200 billion lent back into the system in the next 12 months in addition to what is already being put out there.

Chinese banks raising capital is a clear indication that they are gearing up for a credit expansion, and this also feeds into our 2011 call for profit growth.  

So what's your call for the Shanghai index level for the end of the year?
Our call and belief is to see the Shanghai A-share index break 3,500 points this year, and all-time highs over 6,000 points by the end of 2012.

Exports, autos and heavy manufacturing will moderate to single-digit growth, but service and consumption industries including media, technology, retail sales, telecoms and others are likely to experience 30-100% earnings growth in the coming few years. Those [sectors] are where the Chinese economy and our funds are shifting. 

China is getting out of the sweat-shop business and into the post-industrial service and consumption model. Expect to see more wage increases in China, a loss of low-income, sweat-shop jobs and a huge pick-up in more skilled-labour jobs ranging from services to retail and technology.  

Aren't you always publicly positive and bullish on China though? You were six months ago, and the market went down. 
We are long term investors in this market and we think being involved at any time is wise. It will continue to make new all-time highs in the medium to long term as it has for the past 20 years. No-one can call the market perfectly and we have called it better than any of our peers for two of the past three years.  

We've never called a bottom like this though over the course of several years like we're doing now, and we're among the most qualified people to make a call like this given our specialty in Shanghai A-shares for over six years. We're over 100% allocated to the market, and have never been at this high of an allocation level -- the turn of the tide is coming.

In contrast, we were the best-performing manager during 2008 (when the Shanghai market fell), and we saved our investors a lot of money simply by taking money off the table and staying near 50% cash for the year, so we are not all bullish all the time.  

You can't be right every time. OK, losing 30% of capital is not a pleasant return, if you'd bought at the peak of the recent cycle, but vindication is coming soon in our view.

The media doesn't see the whole Marco Polo picture. We are positive and bullish at the times we go out and talk to the media. There are times we don't feel bullish and we go into cash, and we relay that to our investors in our newsletters each month.

We don't go out to the media and talk down the market, we leave that to the short-sellers who ruin lives; it's just not us. Besides, we wouldn't want China or our clients to witness us being overly critical or publicly pessimistic to the media, we are not interested in losing face.  

So when then would we feel the market is overvalued? I'd say when P/E valuations exceed 40 times. The average multiple for Shanghai is 30-35 times. Today it is 12 times for 2010.

We have the prospect of 2011 and 2012 of around 30% profits growth, which has been around the market average for a decade. That would bring us to a 6 times P/E level at current market prices by the end of 2012.  

If you're right and the index is over 3,500 by the end of the year, will you tell investors to take money out?
No; we are looking for fresh all-time highs over 6,000 points by the end of 2012, and a fair P/E valuation of 20-25 times. Although historically we have been more than 50% cash four times --which proves we are not bullish all the time -- we certainly are [bullish] now.

We use cash opportunistically to re-enter the market with timing built into the mechanisms of the fund. If the Shanghai market makes new highs in the next 24 months, then expect our cash position to go up to perhaps 40% or more.  

And if you're wrong? What if the market ends 2010 lower than today?
We hold, and continue to try and raise capital, while we await the Chinese investors' return to the market.

Come on, you've just made what you say is one of your biggest calls ever. That doesn't sound like a very big reaction should you get that call wrong...
We will continue doing what we do and investing for the long term in a market we truly believe in.