Even I Can’t Avoid Writing About the Chinese Stock Market

If economic forecasts only exist to make astrologers seem respectable, the stock market forecasts only exist to make economic predictions seem respectable.  As Chinese stock markets have spent the past year or so on a rampage that would make any Party chiefs child proud, I have done my absolute best to avoid writing about it.  I only decided to write about it, with a few follow up posts, because I think there are numerous poor stories and interpretations about what is happening.  My focus here will be on providing data and detail that I don’t think is being recognized.

The first question is whether or not there is a bubble in the Chinese stock market.  Most people, and very understandably, argue there is clearly a bubble.  While I generally agree with this view point, the reality is much more nuanced than that.

One of the most enduring lessons I have ever learned about China is from the Yasheng Huang book Capitalism with Chinese Characteristics that probably more than anywhere else, details matter if you want to understand what is happening.  In our case, people who argue there is a bubble point to astronomical PE ratios while those who have bravely argued there isn’t a bubble point to while somewhat high much more reasonable PE ratios.

Here is the misunderstanding: the Chinese stock market is bifurcated.  In geek speak, we would say that there is a bimodal distribution with one part of the market doing one thing and the other part of the market doing something completely different.  Since 2010, the average Shanghai PE has been 15.4 while the Shenzhen board has clocked a significantly higher 30.7.  More recently, while Shenzhen has been on a tear with the average PE topping 60, the Shanghai market only in May topped 20.  In fact, it wasn’t even until March that the Shanghai board topped 18.

While I believe the 20 PE is overvalued for other reasons, I think you would have a difficult time making a solid argument that the Shanghai market is radically over valued in a bubble driven mania.  In fact, if you believe that official growth numbers, even with slowing growth, let’s assume 7% GDP growth, a PE of 20 probably is not entirely unreasonable speaking in generalities for major red chips. Conversely since 2010, the Shenzhen board has averaged a PE of 31 and broke that barrier in November last year.  Even as late as February it was trading at a PE of 39.  In the past few months however, this number has exploded and recently hit 61 with a median PE much higher.

When you look beneath the headlines at individual stocks, you see very similar patterns of firms and how the market is pricing them.  In Shanghai, such major red chips as Agricultural Bank, Bank of China, and ICBC have PE’s of 7-8.  The bulk of Chinese industry from banks, securities, car companies, steel, real estate, power, and airports all of which are very large and state favorites, all have very reasonable though in my estimation somewhat high valuation.  These valuations are even more reasonable if you believe the expected path of growth and earnings.  The firms with astronomical PE ratios, regardless of whether they are listed in Shanghai or Shenzhen, tilt much more heavily to different industries that I would strongly suspect, though I don’t specifically have data on this topic, to be private or near private firms.  Pharmaceuticals, hi-tech, new energy, and of course my favorite clothing firm Metersbonwe.

Though I have no specific data on this, given the space that many of the firms occupy in Chinese industry with low valuations, I would strongly suspect that the amount of GDP and corporate profits linked to firms with lower PE is a grossly disproportionate share relative to firms with above median PE.

All of this analysis matters for a couple of reasons.  First, the headline grabbing numbers of astronomical PE’s are probably distorting the picture a little of what is really happening.  Second, the headline number run ups are not from firms who are responsible for most of Chinese GDP.  Third, any fall in the stock market in the absence of related economic events, will probably have a more muted impact on the major firms and broader economic activity.  Fourth, given all the additional risk factors, not just basic PE analysis, investors are probably assuming a lot more risk than they believe investing in these types of firms with high valuations.  Fifth, there is probably more muted financial and economic risk from a stock market decline, but significant political risk if investors feel cheated.

I believe major Chinese firms are currently overvalued but more due to earnings quality and future economic risks.  If you believe future growth prospects and earnings quality, there is a strong case to make that the major firms are not overvalued or not enormously overvalued.  There seems to be a much stronger case that smaller and private firms are significantly overvalued though I believe any decline would have a more muted impact on the Chinese economy in the absence of other events.

Here is some PE data on markets and individual firms and I will be presenting some other data refuting other misconceptions about high share prices later this week.

Capital Use and Measuring GDP in China

A more arcane but incredibly important area of economics, that gets overlooked, is how to measure GDP.  The classical example goes like this.  Assume you have two guys who live in a country and each guy has $100.  The first offers to pay the second guy $100 to dig a hole.  The second guy tired from digging the hole, offer the first guy $100 to fill the hole back up.  According to economic accounting, this accounts for $200 of GDP even if nothing was actually accomplished.

Theoretically, GDP growth of this nature can continue infinitely.  However, in reality, this type of GDP growth results ultimately in significant losses, though it can continue for some time before it collapses.

The reason I mention this relatively arcane discussion about how to calculate GDP is that this problem is incredibly relevant to understand the potential difficulties facing China.  Let me emphasize that I do not have a good answer and the data on more esoteric  or politically sensitive issues is even worse than the baseline numbers.

In the past week there have two pieces in Quartz about the poor quality of older Chinese housing that is now collapsing and another on whether China actually has a housing bubble because so much of the housing stock is being turned over.  While it is perfectly reasonable to ask what impact China’s existing housing stock has on promoting or preventing a bubble, this overlooks two much more fundamental and important issues.

First, how efficiently is capital being allocated in China?  Analysis of Chinese finances and a potential bubble typically focuses on a housing bubble or over capacity in specific industries like steel or solar.  However, there is evidence that there is wide spread misallocation of capital throughout the Chinese economy and that the capital is poorly utilized.  Houses are being built, torn down, and rebuilt and GDP goes up but the quality of that GDP, similar to the example of holes, is in real doubt.

Second, if capital is being poorly allocated, for instance in the case of substandard housing that is destroyed relatively soon after being built, what does that say about historical GDP and capital accumulation?  Put another way, if capital is being consumed or is idle rather than deployed into productive purposes, this has the net effect of raising past GDP while depressing current or future GDP.

Let me build on the simple example from earlier about two guys digging and filling in holes.  Now let’s assume the first guy builds a house and sells it to the second guy who takes out a 30 year mortgage to pay for it.  Then after 10 years the house starts falling apart and guy #2 has to move and buy a new house.  There will be a large capital loss by the owner, a developer to purchase the house at market rate to build a new house, or an insurance company.

Consider a second scenario where the house is fine but after 15 years a developer or the city want to tear it down to build bigger, nicer, and newer houses, a very common phenomenon in China.  The developer will have to purchase at near market rate the old house in order to build a new one.  This capital cost will then be passed on to the new purchaser.

This poor allocation or destruction of capital is not limited to real estate but carries over into all other industries.  Over capacity in solar and steel where $500 billion in debt gets you $300 million USD in profits, are the obvious culprits, but under utilization of capital is rampant in China.  According to S&P data, Sinopec and PetroChina pay less than what many governments pay on their debt but also earn an incredibly low rate of return on capital and half of what ExxonMobil earns.  Put another way, in the most capital intensive industry on the planet, Sinopec and PetroChina earn a rate of return on capital that would barely break even for most competitors.

Chinese companies are coming up with ever new and creative ways to hide these capital losses.  The Wall Street Journal is reporting that Chinese banks have devised a plan to sell bad loans to their investment banking arms to try and restructure them.  The bank does not have to report a non-performing loan and receives a higher price for the soured loan than it would on the open market allowing the bank to mask the true picture.

Having lived in China, I can personally attest to the amazing misuse of capital.  Whether it is buildings being torn down ten years after being built or looking out my window and seeing half empty office buildings.  Unfortunately, measuring the “misallocation” of capital is an incredibly hard thing to do

Capital ultimately represents a cash flow, whether that is a machine that makes things or an apartment that someone lives in.  Imagine the losses incurred when you learn that more than 70% of Chinese airports are operating at a loss.  China Railway Corporation announced plans to put together a private investment fund after corruption scandals and losses forced it to give up its status as the Railway Ministry.  The losses it currently sits on are enormous and there is valid concern over its ability to profitably exist without government handouts.  The capital has to receive a stream of cash to pay for the investment or revalue the investment and the cost of the product.

Despite the pictures of gleaming skylines, brand new airports, and bullet trains the cash flows are struggling to pay for the capital used.  Whether through banks, surplus capacity, or a revaluation of the asset and the product, at some point this is going to result in significant losses.

China, Inc.: Unleashing or Caging the Dragon?

Apologists for the still state run economy of China like to argue that without the large investment and the guiding hand of favored state owned enterprises, Chinese business would not be competitive.  This logic is used to defend the ongoing channeling of credit to favored firms and the rapid expansion of debt levels in special purpose vehicles backed by local governments.

The Chinese consumer, however, has chosen its preferred companies quite clearly and the winners are not state owned enterprises.  According to a recent study, private brands grew three times faster than state owned brands.  While state owned firms were producing respectable brand returns at 9%, private brands were  innovating, improving efficiency, and building brand loyalty returning 27%.

Private brands are outperforming because to compete with state owned giants, they need to produce a better product, cheaper, and building more consumer trust.  As one of the authors of the study notes, “…consumers are gravitating toward brands that promise them high quality of life and trust.”  Chinese consumers are moving beyond price as the determining factor becoming increasingly discerning shoppers.

Nor is this expansion of brand value limited to high end luxury good makers but rather spread across the consumer spectrum.  The third most valuable brand in China Tencent with its popular QQ chat program and most surprisingly is food and dairy company Yili which is the 15th most valuable, which has tried to carve out a niche as a trusted provider of milk and milk powder.  In fact, 2 of the 5 fastest growing brand values came from private dairy firms.

While there is almost no week that passes without some new public food scandal, both Chinese companies and consumers are rapidly learning about their mutual relationship.  Private firms understand the brand loyalty and consumer trust are valuable assets that take years to build but can be destroyed in a day.  Private firms in China are working to build that trust and provide value to consumers.

Chinese consumers are learning about the power they have over companies.  Companies need to compete for the consumers business and if they are dissatisfied, other competitors are willing to fight for their business.  Chinese consumers have choices and are increasingly willing to exercise the power of the purse to get what they want.  They can find milk producers selling untainted milk and companies that value and compete for their business.

While Chinese brands have not established brand names outside of China, numerous private companies have incredible potential to be the first major Chinese brand overseas.  Lenovo with its line of well priced but top quality smart phones is a formidable competitor with Apple and Samsung given the pricing pressures from populations demanding more for less.  Tsingtao is a great beer and would be a great cultural ambassador if it can find the right international partner with better distribution.  At best it seems unlikely that any state owned firm will be a major player in international markets and none with the product line and price needed to make an impact.

The recent reforms declared a desire to increase the role of the market.  Rather than restricting Chinese economic development and growth, private companies are growing faster, innovating more, providing better product value, and building greater brand loyalty among consumers than the favored state owned firms.  Hopefully, the impact of private firms will be seen as positive unleashing the potential of the dragon and the power of Chinese firms and consumers.

A full copy of the report can be found here in English and here in Chinese.