Author : Eddy Wong
The China equity market, represented by the Hang Seng Mainland Composite Index (HSMLCI), continues to drop sharply in 2008. The HSMLCI saw a 19% (in SGD terms) drop in October. In fact, the index dropped to a 3-year low and closed at 1794.24 points on 27 October 2008. This means that the index had dropped 36.7% (in SGD terms) during the first 27 days in October!
After the crazy sell-down in September and October, we believe that China equities are at their most attractive level in a decade, and we have therefore decided to upgrade China to 5 Stars, the best possible rating!
Chart 1: The HSMLCI dropped more than 50% this year!
Markets have collapsed since October 2007. After a painful market slump for more than a year, we believe that China is one of the best markets to buy at this point due to its attractive valuation. A sharp slowdown in the global economy seems likely in the coming 12 months. Also, we have seen a huge correction in commodities over concerns from the impact of a global recession. This suggests that the future demand for commodities could decline.
As wealth growth slows and demand softens, investors may be concerned about the possibility of a “hard landing” in China. We agree that China’s economic growth will slow further. Having said that, we are not expecting China to experience a “hard landing” in 2009! We think that investors could be overly pessimistic when they worry that China will head for a “hard landing”. Equities are facing a huge sell-off even when valuations are extremely low. We all know that “Buy Low and Sell High” is the ultimate goal for every investor, and now that the market is so low in terms of valuation, there is no doubt that it is a good time to invest in China!
No “Hard Landing”!
“Hard Landing” refers to the economic growth of a country shifting from a period of expansion to contraction within a very short period of time. For the case in China, since its economy has been expanding at a relatively high speed, we consider that the economy may undergo a “hard landing” if it expands at a rate of less than 6% year-on-year. The 3Q GDP growth is only 9% year-on-year, the slowest pace in more than 5 years. In fact, China’s economy expanded 9.9% year-on-year in the first three quarters of 2008. Economic expansion dropped to below 10%, so what does that mean?
It simply means that the Chinese economy is affected by the credit crunch across the world and hence its economic growth has dropped from a skyrocketing pace. But its growth rate is still faster than its Asian peers.
According to the International Monetary Fund (IMF), the world is estimated to expand by 3.7% in 2008 and 2.2% in 2009. In Emerging markets, the estimated growth is 6.6% for 2008 and 5.1% for 2009. However, China is estimated to grow by 9.7% in 2008 and 8.5% in 2009. Since the Chinese economy is still growing at a rate faster than its peers even during a global economic slowdown, it would be a more attractive investment destination than the other emerging markets such as Russia or India.
Table 1: The World Is Slowing
Source: IMF, World Economic Outlook, November 2008
If we look at the breakdown of the contribution to China’s GDP growth from net exports, consumption and investment, we find that the possibility of having a “hard landing” is nearly impossible. In 2007, the contribution to GDP growth by net exports, consumption and investment were 22%, 39% and 39% respectively. In the first 3 quarters of 2008, the contribution by the net exports dropped from 22% last year to only 12.5%. In fact, the Chinese economy expanded 9.9% in the first 3 quarters in 2008 vis-à-vis the first 3 quarters in 2007. It means that the net exports contributed 1.2% to the growth in China’s GDP in the first 3 quarters of 2008. As the demand for Chinese goods is expected to drop in late 2008 and 2009, we believe that the contribution by the net exports will continue to decrease. Even if contribution of net exports to GDP is reduced drastically, we expect the economy to grow more than 7%.
Another supportive factor for economic growth would be that Chinese households tend to save excessively in banks. As a result, it is not surprising that Chinese consumption has remained relatvely resilient, despite the sharp decline in the stock and property market. Retail sales increased 22% year-on-year in the first 3 quarter in 2008. A pick-up in domestic demand is going to play a more important role in supporting the economic growth.
On Fixed Assets Investments (FAI) - it increased 27.0% year-on-year in the first 3 quarters in 2008. Real estate development continued to slow and increased by less than 30% year-on-year in August and September 2008. At the same time, due to the increasing railway transportation spending by the government, FAI continues to grow strongly. Investors may worry if “hot money” stops flowing to China, or could even leave the country.
According to Alliance Bernstein, there was an estimated modest speculative inflow of around US$5.5 billion in the 3Q 2008, compared with more than US$60 billion and US$20 billion in the 1Q and 2Q 2008. Although credit has tightened sharply in the 3Q, monies are still trickling through to China and we do not expect any significant outflow of monies in the coming future.
After a full body checkup of China, we believe that a “hard landing” is not likely to occur in 2009. However, we do agree that economic growth will slow, affected by the external factors such as decreasing in demand for Chinese goods. Hence, corporate earnings may be hurt as well. If we are not expecting a “hard landing” in China, we should be able to examine the attractiveness of the Chinese equity market by looking at valuations.
Stimulus Package
On 9 November, the Chinese government announced a stimulus package with 10 measures to boost domestic demand growth. A total of 4 trillion yuan (US$586 billion) will be spent by the end of 2010. Plans include support for low-end and public housing, infrastructure in rural areas and building more railways, highways, airport etc. This package and the aggressive rate cut by the People’s Bank of China since September can help to support domestic demand. As we mentioned above, consumption is one of the most important contributors to China’s economic growth. We believe that the bottom line for the Chinese government is to maintain its growth at higher than 8% in 2009.
It is all about valuation!
Chinese equities used to trade at higher than 15X PE since November 2003. However, the PE level has dropped significantly from about 34X in October 2007 to about 10X in October 2008. According to our estimates, the PEs for the HSMLCI index are 10.3X and 9.1X for 2008 and 2009 (as at 7 November). It is the lowest since the index was launched.
In fact, we believe that the index already bottomed at 1794.24 on 27 October 2008!
Despite all this pessimism and the recent downward earnings revision, we have upgraded the China equity market to 5 stars – Very Attractive. We believe that current valuations have overpriced the negatives, resulting in an undervalued Chinese equity market. Another important component for examining the attractiveness of a market is the estimated earnings growth. The estimated earnings growth for 2008, 2009 and 2010 are 11.7%, 13.9% and 17.6% respectively. It is one of the strongest amongst Asian countries.
Chart 2: PE hit all time low!
Conclusion
There is no denying that China is not insulated from the global credit crunch. However, we believe that China has strong fundamentals to withstand this financial tsunami. When we look back at the basics of investing, valuations of Chinese equities look extremely attractive. In addition, we believe that the market has hit bottom in October, and hence, we have upgraded China to 5 stars – Very Attractive.
We saw panic selling in September and October. The best investment strategy is to buy when others are panicking and sell when others are too excited. Are you panicking and waiting for the market to shoot up? Or are you investing now to obtain the huge potential upside with a limited potential downside risk? I belong to the latter group of investors. How about you?
Source:
fundsupermart.com
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