Research

The China Show: How Will it End?

Hedge fund managers contemplate the effects of China’s nouveau riche consumer, and where income disparities might ultimately lead the People’s Republic.

With first-quarter GDP growth estimated to be possibly as high as 12-15%, China continues to experience a spectacular secular phase of growth comparable to that of Japan in the 1970s and 1980s. Hedge fund managers are considering where China’s markets go from here.

Having waited a decade for a full-fledged bull market, they are very much in love with the markets right now.

“Chinese companies are delivering earnings per share(EPS) growth after so many years, and given current earnings multiples and dividend yields I think there may be a upward re-rating,” says Yang Liu, managing director at Atlantis Investment Management in Hong Kong. “You have currency strength as a long-term catalyst and you have momentum.”

She made her remarks last week at a hedgefund conference organised by GAIM in Hong Kong.

Consumer stocks have been the hot properties in China lately, in expectation that the population is about to embark on a giant shopping spree. Yang thinks that with consumer stocks trading at 35x earnings, she sees value in healthcare companies with multiples of 8x.

The consumer theme remains in vogue in China, especially with the Olympics just over one year away.

“We are seeing the change from an investment-driven economy to one which is consumer based, “says Kenrick Leung, portfolio manager at FrontPoint’s Greater China fund. “Companies that can deliver earnings growth will differentiate themselves from those who cannot.”

So what will happen in the end of this current chapter? There seemed some acceptance among portfolio managers that vertiginous returns are not there permanently.

“Capital is misallocated, and it may end in tears at some stage,” says Khiem Do, head of Asian multi-asset investments at Baring Asset Management. “For private equity, you can still buy a company at a cheap price-to-earnings ratio(P/E ratio) of 7x compared to the market P/E of around 28x. I think that market P/Eratios may top out at 60x, as it did a few years ago, because I can’t see interest rates rising significantly. I could envisage ultimately A-share and H-share valuations converging at a P/E ratio of about 40x.”

Corruption, fraud and theft in China are a worry, and hedgefund managers can see the psychological effects these factors have on investors. The private sector in China seems more adept at trying to tackle the problem.

“Managers’ interests have been aligned with investors’ by shadowed or real options,” says Sunny Li, managing director at Pinpoint Asset Management. “Their bonuses are correlated with share prices. Because business managers want their stock to appreciate it makes them keen to meet with fund managers.”

Portfolio managers say there is a rift between the private sector and state-owned enterprises when it comes to corporate governance. Some listed private companies are more proactive.

“State-owned enterprises account for 350 of 500 Chinese companies listed overseas,” says Yang. “They feel very differently about corporate governance than do private-sector companies. However, at least the top-down interest means that whatever happens, they won’t go bankrupt, which mitigates the risk.”

Shorting on the index is slated to start in the next three months, and when stock borrowing is permitted, whether sourced from some central hub or via brokerages, then that may wobble the markets, or it may encourage investors to go long in the first place, mindful that they can exit easier. The ramifications of allowing shorting will become clear soon.

China has become a sophisticated economy and the Chinese bureaucrats managing it are having to learn quickly, given the giant leaps forward in the economy’s complexity that continue to take place. Private-property rights that take real-estate owners from a leasehold to a more freehold-oriented system have only been agreed by China’s rubber-stamp parliament last month.

This current chapter may end with the conventional market ending as asset prices moderate, but China is in unknown territory: a Communist country trying to become capitalist, at the same time as remaining a one-party state.

Some people are getting fabulously wealthy taking the capitalist road. Yet the Chinese majority, whilst they have no plans to stay poor, do not seem to have much choice in the matter. The income inequalities are a feature that concerned all hedgefund managers speaking at the GAIM event. As a long-term social issue, nobody knows where this could end. One panellist even muttered the dialectic term: “Revolt!”

This article first appeared on www.asianinvestor.net.

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