Is China Breaking Out or Breaking Bad?

China’s recent stimulus announcements sparked a massive rally in its stocks, and a growing chorus of analysts see more gains ahead. Is this a reawakening of the country’s long slumbering stock market or just another false start? Bloomberg Opinion’s Nir Kaissar and Shuli Ren, based in the US and Hong Kong respectively, met online to discuss the risks and opportunities.

Nir Kaissar: Shuli, like a lot of people, I’ve been amazed by the surge of Chinese stocks in recent days.

The Hang Seng Index is 22% higher and the Shanghai Shenzhen CSI 300 Index is up 27% in just two weeks. Those are big leaps by any measure.

And yet, they seem overdue. Some of these moves are probably a response to recently announced stimulus in China, but I wonder if investors are finally waking up to how cheap Chinese stocks are, on an absolute basis and relative to their profitability.

Among the bulls is hall of fame investor David Tepper, who told CNBC recently that he’s buying “everything” in China because its companies trade at “single multiple P/Es with double-digit growth rates.”

Here are some of the numbers Tepper is talking about: Before this recent surge, the Hang Seng index traded at 9 times forward earnings, which was not new. That price-earnings ratio has averaged 11 times since 2013 — the first year for which numbers are available for both the Hang Seng and CSI 300 — and that multiple has mostly hugged a tight range of 8 to 12 times during that period.

Valuations that low are usually associated with catastrophic events like financial crises and pandemics or with companies that are near bankruptcy. China has its problems, but Chinese companies have churned out reliable profits for years. The Hang Seng posted a return on equity of 11% last year, and analysts expect an ROE of 10% this year. Since 2013, ROE has mostly been in the range of 9% to 13% and never far from it.

The same history largely applies to the CSI 300 index, except that it has been a bit more expensive but also more profitable. Even now, Chinese stocks are cheap, with the Hang Seng trading at 11 times and the CSI 300 at 15 times this year’s earnings.

All of that is a long windup to ask you: Why have Chinese companies been so cheap for so long, and what accounts for this reawakening?

Shuli Ren: You are right, Nir. Even after the recent rally, Chinese equities are still not expensive. MSCI China is trading at 11.4 times forward earnings, roughly half of where the S&P 500 Index is at. At its early 2021 peak, MSCI China was valued at only a 15% discount to the S&P 500.

What we have seen over the last four years is a steady de-rating of Chinese equities. China used to have a lot of growth stocks. ATM, or Alibaba Group Holding Ltd., Tencent Holdings Ltd. and Meituan, was its version of the Magnificent Seven. However, the government’s regulatory crackdowns on big tech — halting Alibaba’s fintech unit Ant Group’s IPO, issuing billion-dollar anti-trust fines, to name a few examples — greatly deflated the valuation premium enjoyed by Chinese tech companies. And then there’s the three-year-long property downturn that changed the mindset of investors. They no longer see China as a growth market, but another value trap like Japan.

This recent awakening is caused by a sudden change in rhetoric from the government. Since China’s abrupt exit from Covid Zero in late 2022, top officials have been resistant to the idea of a supercharged stimulus, prompting worries that Beijing would just sleepwalk China into becoming the next Japan. And now we have a government that vows to bring the big guns out. 

So in the investing space, asset managers must decide what China really is. Is it still a growth market that has hit a few roadblocks but is nonetheless able to turn around, or a value trap that can only stage dead cat bounces? 

NK: I suspect valuations will expand in China, even though the timing is impossible to know. When I think of value traps, I think of companies that were once profitable but may never be again. In this case, many Chinese companies are already highly and reliably profitable. The vibes are off.

I also suspect investors are overlooking some solid companies merely because they’re Chinese. Apparently, there’s a “Lucky Eight” exchange-traded fund in the works that will invest in Chinese Big Tech — sort of like a Magnificent Seven fund for China — with names that include Tencent, Alibaba and Baidu Inc.

In exchange for an average multiple of 18 times forward earnings, analysts expect these eight companies to deliver an average ROE of 19%. Not a bad tradeoff. Yes, the Magnificent Seven’s profitability is 50% higher, but their valuation is also twice that of the so-called Lucky Eight.

SR : Some of the Lucky Eight were not so lucky, because of the government’s regulatory crackdowns. However, they are highly competitive companies with proven operational track records. For instance, PDD Holdings Inc.’s Temu app is making fast inroads in the US. BYD Co. is neck and neck with Tesla Inc. in terms of battery EV sales. Food delivery giant Meituan’s gross profit margin hit a record high even though the Chinese economy is faced with deflationary pressure. In addition, big tech is doing a lot of buybacks.

There is also good reason to believe the government’s regulatory crackdown is finally over. After all, the Lucky Eight are big employers of China’s educated youth. Chinese universities churn out more than 10 million graduates annually, and the Class of 2024 is the third graduating year to deal with a tough job market. The latest youth unemployment rate came in at 18.8%, double that in the US.

NK: As China has shown, regulatory risk is an under-appreciated hazard for highly profitable businesses. When a company is minting money, it usually doesn’t take long for new competitors or government regulations to chip away at margins.

Back to fundamentals in China, we should probably give readers some basis for comparison. The MSCI Europe Index, for example, trades at 15 times forward earnings in exchange for an expected ROE of 13% for this year.

That’s a slightly worse tradeoff than the one Chinese stocks offer, but the more significant difference is that, while average profitability for Chinese and European stock indexes has been comparable historically, the financial results of European companies are a lot more volatile, often swinging wildly from year to year. Consistency is a mark of quality that investors look for, and they’re often willing to pay a premium for it. And yet, Chinese stocks trade at a discount to European ones.

That reminds me of a criticism I often hear about China: that financial reporting and oversight is too lax. The US and Europe have had their fair share of financial scandals, perhaps most notably in recent years the collapse of FTX cryptocurrency exchange. And public companies everywhere are no strangers to accounting games — just listen to Warren Buffett’s rants about the use of Ebitda, for instance.

How should investors think about the reliability of financial results in China, particularly when their consistency might strike some as too good to be true?

SR : Absolutely, earnings inflation is a problem everywhere and investors should always conduct due diligence. However, recall when China Inc., such as Luckin Coffee, had their accounting scandals? That was when China was still seen as a growth market and had frothy valuations. That froth is gone now. 

NK : There’s a related question about rule of law more generally. I would argue that rule of law is stronger in the US and Western Europe than in China. I have said that markets discount the valuations of companies that operate in countries with weaker rule of law. To what extent are we seeing that in Chinese valuations?

SR : Yes, instead of accounting scandals, country risk is now the biggest problem investors have to think about when they purchase Chinese stocks. This administration’s economic policies have been clumsy and abrupt, and its geopolitical jostling with the White House puts global asset managers in a tough spot. No one wants to end up holding shares of companies that might be sanctioned by the US. 

So in this sense, even if Beijing can successfully reflate its economy, offshore Chinese equities may never return to their peak 2021 valuation. Not in the foreseeable future, at least. 

NK : Much of what we’re talking about applies to emerging markets more generally, particularly as to how cheaply they currently trade and have for a long time. China comprises nearly a third of the MSCI Emerging Markets Index. Investors who own an emerging markets fund probably have a sizable stake in China.

Is an allocation that high to China in EM funds warranted? Is a broad basket of EM stocks a good hedge against country risk in China? Or should investors have even more China exposure than EM funds generally provide?

SR : It’s very valid to be concerned that China is morphing into something too big for emerging markets. It was all good when China was seen as a growth market, because global asset managers were piling in, benefiting all boats in the same asset class. But hot money has been fleeing China in the last few years, pulling others down with it. 

So one popular notion is so-called emerging markets ex-China, and asset managers have been promoting passive funds that track these kinds of indices. But the verdict is still out on whether this is a viable solution. Other developing nations don’t have the kind of liquidity China provides, and can you truly invest in emerging markets without exposure to China? China remains a big commodities importer, and Chinese companies are big investors in the Global South, opening manufacturing facilities from Turkey to Mexico. 

India is perhaps the best hedge to China, but it has a lot of issues as well, lofty valuation being just one of them. MSCI India trades at around 24 times earnings, and India has its own fair share of irregular accounting allegations — Adani Group is the most famous case.

Over the last year, investors have been looking for the next China. India was floated as a possible beneficiary; Vietnam too, for its heavy exposure to manufacturing. But is it possible that after all the searching, the next China is still China? This debate is sure to surface if the bull market in Chinese equities continues. 

More From Bloomberg Opinion:

Hang Seng Index tracks about 80 stocks that trade on the Hong Kong stock exchange.

The CSI 300 tracks 300 stocks listed on Shanghai or Shenzhen exchange.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Nir Kaissar is a Bloomberg Opinion columnist covering markets. He is the founder of Unison Advisors, an asset management firm.

Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. A former investment banker, she was a markets reporter for Barron’s. She is a CFA charterholder.

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