I have generally steered from using my blog as a vehicle for rants, not because I don’t have my share of targets, but because I know that while ranting makes me feel better, it almost always creates more costs than benefits. It is true that I have had tantrums (mini-rants) about the practice of adding back stock-based compensation to EBITDA or expensing R&D to get to earnings, but the targets of those tend to be harmless. After all, what can sell-side equity research analysts or accountants collectively do to retaliate? Refuse to send me their buy and sell recommendations? Threaten me with gang-audits?
This post is an exception, because the target of the rant is China, a much bigger and more powerful adversary than those in my mini-rants, and it is only fair that I let you know my priors before you read this post. First, I am hopelessly biased against the Chinese government. I believe that its reputation for efficiency and economic stewardship is inflated and that its thirst for power and money is soft-pedaled. Second, I know very little about the Chinese economy or its markets, how they operate and what makes them tick. It it true that some of my ignorance stems from the absence of trustworthy information about the economy but a great deal of it comes from not spending any time on the ground in China. So, if you disagree with this post, you have good reason to dismiss it as the rant born of ignorance and bias. If you agree with it, you should be wary for the same reasons.
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The Chinese Economic Miracle: Real or Fake?
For the last two decades, the China story has been front and center in global economics, and with good reason. In the graph below, you can see the explosive growth in Chinese GDP, measured in Chinese Yuan and US dollars:
The Chinese economy grew from being the eighth largest in the world in 1994 to the second largest in the world in 2014. It is true that many of the statistics that we use for China come from the Chinese government and there are is reason to question its reliability. In fact, there are some with conspiratorial inclinations who wonder whether the Chinese miracle is a Potemkin village, designed for show. Much as my bias would lead me down this path, there are some realities on the ground that are impossible to ignore:
- The China growth story is real: Any one who has visited China will tell you that the signs of real growth are around you, especially in urban China. It is not just the physical infrastructure of brand new airports, highways and high-speed trains, but the signs of prosperity among (at least some of) its people. I did my own experiment yesterday that confirmed the reality of Chinese growth. After I woke up to the alarm on my China-made iPhone, I put on my Nike exercise clothes, manufactured in China, slipped on my Asics running shoes, also from China. As I went through the day, it was easier for me to keep track of the things that were not made in China than those that were. Based just on that very unscientific sampling, I am willing to believe that China is the world’s manufacturing hub.
- It has a Beijing puppet-master: To those who celebrate the growth of the Chinese economy as a triumph of free markets, I have to demur. The winners and losers in the Chinese economy are not always its best or most efficient players and investment choices are made by policy makers (or politicians) in Beijing, not by the market. There are those who distrust markets who would view this as good, since markets, at least in their view, are short term, but trusting a group of experts to determine how an economy should evolve can be even more dangerous.
- It is driven by infrastructure investment, not innovation: The Chinese economy is skilled at copying innovations in other parts of the world, but not particularly imaginative in coming up with its own. It is revealing that the current vision of innovation in China is to have a CEO dress up like Steve Jobs and make an Android phone that looks like the iPhone. Note that this should not be taken as a reflection of the Chinese capacity to be innovative but a direct consequence of centralized policy (see prior point).
- The China story is now part of every business: In just the last month and a half, I have been in the US, Brazil and India, and can attest to the fact that the China story is now embedded in companies across the globe. In the US, I saw Apple report good earnings and lose $100 billion in market capitalization, with some attributing the drop to disappointing results from China. In Brazil, my Vale valuation rests heavily on how China does in the future, because China accounts for 37% of Vale’s revenues and the surge in iron ore prices in the last decade came primarily from Chinese infrastructure investment. In India, I valued Tata Motors, whose acquisition of Jaguar , has made them more of a Chinese company than an Indian one, dependent on the Chinese buying oversized Land Rovers for a significant portion of their profits.
- It is also a weapon of mass distraction: In a post from a few months ago, I talked about weapons of mass distraction, words that analysts use to induce you to pay premiums for companies and to distract you from specifics. In that post, I highlighted “China” as the ultimate wild card, with mention of exposure to the country operating as an excuse for pushing up the stock price. The problems with wild cards though is that they are unpredictable, and it is entirely possible that the China card may soon become a reason to discount value, as the handwringing about earnings effects and corporate exposures of the China crisis begins.
The Chinese Markets: All Pricing, all the time!
If you have been reading the news for the last few months, which have been about the epic collapse of Chinese stocks, I would not blame you for feeling sorry for investors in the Chinese market. I would suggest that you save your sympathy for more deserving causes, because as with everything else in markets, it depends on your time perspective. In the chart below, I look at three charts that look at the Shanghai Composite over time:
It is undeniable that markets have been melting down since June, with the Shanghai Composite down 32% from its peak on June 12. However, if you had invested in Chinese stock at the start of this year, you have no reason to complain, with a return of 8.44% for the year to date, among the best-performing markets globally. Stepping even further back, if you had invested in Chinese stocks in 2005, you would have earned close to 13$ as an annual return each year, with all the ups and downs in between.
In earlier posts, I have drawn a contrast between valuation and pricing and why a healthy market need both investors (who buy or sell businesses based on their perceptions of the values of these businesses) and traders (who buy and sell assets based on what they think others will pay for them). A market dominated mostly by investors will quickly become illiquid and boring, and ironically reduce the incentives to collect information and value companies. A market dominated by traders will be volatile, with price movements driven by mood, momentum and incremental information, and will be subject to booms and busts. I would characterize the Chinese stock market as a pricing market, where traders rule and investors have long since fled or have been pushed out. While there are some who will attribute this to China being a young financial market, and others to cultural factors, I believe that it is a direct consequence of self-inflicted wounds.
- Investor restrictions: There is perhaps no more complicated market to trade in than the Chinese markets, with most Chinese companies having multiple classes of shares: Class A shares, and traded primarily on the mainland, denominated in Yuan, Class B shares, denominated in US $, traded on the mainland and Class H shares, traded in Hong Kong, denominated in HK$. The Chinese government imposes tight restrictions on both domestic investors (who can buy and sell class A shares and class B shares, but only if they have legal foreign currency accounts, but cannot trade in class H shares) and foreign investors (who can buy and sell only class B and class H shares). As a consequence of these restrictions, investors are forced into silos, where shares of different classes in the same company can trade at different prices and governments can keep a tight rein on where investors put their money. Note also that the highest profile technology companies in China, like Baidu and Alibaba, create shell entities (variable interest entities or VIEs) and list themselves on the NASDAQ, making them effectively off-limits to domestic investors.
- Opaque financials and poor corporate governance: While China has moved towards adopting international accounting standards, Chinese companies are not doyens of disclosure, often holding back key information from investors. It is therefore not surprising that almost 10% of all securities class action litigation in the US between 2009 and 2013 was against Chinese companies listed in the US, that variable interest entities hold back key information and that non-Chinese companies like Caterpillar and Lixil have had to write off significant portions of their Chinese investments, as a result of fraud. This non-disclosure problem is twinned with corporate governance concerns at Chinese companies, where shareholders are viewed more as suppliers of capital than as part-owners of the company.
- Markets as morality plays: The nature of markets is that they go up and down and it is that unpredictability that keeps the balance between investors and traders. In China, the response to up and down markets is asymmetric. Up markets are treated as virtuous and traders who push up stock prices (often based on rumor and grease with leverage) are viewed as “good” investors. Down markets are viewed as an affront to Chinese national interests and not only are there draconian restrictions on bearish investors (restrictions on short selling, trading stops) but investors who sell stock are called traitors, malicious market manipulators or worse. Thus, the same Chinese government that sat on its hands as stock prices surged 60% from January to June has suddenly discovered the dangers of volatility in the last few weeks as markets have given up much of that gain.
The bottom line is that the Chinese government neither understands nor trusts markets, but it needs them and wants to control them. By restricting where investors can put their money, treating short sellers as criminals and market drops as calamities, the Chinese government has created a monster, perhaps the first one that does not respond to its dictates. The current attempt to stop the market collapse, including buying with sovereign funds, putting pressure on portfolio managers, name calling and sloganeering may very well succeed in stopping the bleeding, but the damage has been done.
Moneyball in China
The best cure for bias and ignorance is data and I decided that the first step in ridding myself of my China-phobia would be a look at how Chinese stocks are being priced in the market today. The essence of value investing is that at the right price, any company (including a Chinese company with opaque financials and non-existent corporate governance) can be a good investment and it is possible that the drop in stock prices in the last few months has made Chinese stocks attractive enough for the rest of us.
To make these comparisons, I used the market price data as of August 19, 2015, to estimate market capitalization and enterprise values. For the accounting data, I used the numbers from the trailing 12 months, generally the 12 months ending mid-year 2015, for most companies. The first comparison was on pricing multiples:
I compared China with India, Brazil and Russia, the three other countries that have been lumped together (awkwardly, in my view) as the BRIC, as well as with the rest of the emerging markets. For comparisons, I also looked at the US and the rest of the developed markets (where I included Japan, Western Europe, Australia, Canada and New Zealand). In spite of the drop in stock prices in the last few months, Chinese stocks are collectively more expensive than stocks anywhere else in the world.
To measure the profitability of Chinese companies, I looked at three measures of margin (EBITDA, Operating Income and Net Income) and three measures of return (Return on Equity and Return on Invested Capital):
Chinese companies lag the rest of the world, when it comes to EBITDA and operating margins, but do better than other emerging market companies on net margins. On returns on equity and invested capital, Chinese companies are more profitable than Brazilian companies (reflecting the economic downturn in Brazil in the last year) but are pretty much on par with the rest of the world.
One reason for the superior net margins at Chinese companies is that they tend to borrow less than companies elsewhere in the world, perhaps the only bright light in these comparisons.
That may be at odds with some of what you may be reading about leverage in China, but it looks like the debt in China is either more in the hands of local governments or is off balance sheet.
Finally, if the straw that you are grasping for is higher growth in China, there is some backing for it when you compare growth rates across companies, but only in analyst expectations, rather than in growth delivered:
It is true that this market-level look at China may be missing bargains at the sector level and to remedy that, I looked at PE ratios and EV/EBITDA multiples regionally, by industry grouping. The industry-average values, classified by region, can be downloaded here, but across the ninety five industry groupings, Chinese companies have the highest PE ratios in the world in fifty and the highest EV/EBITDA multiples in fifty eight. You could dig even deeper and look at company-level data and you are welcome to do so, using the complete dataset here.
Overall, I am hard pressed to make a case for investing in Chinese stocks, if you have a choice of investing in other markets, even after the market drop of the last few months. If you are a domestic investor in China, your choices are more restricted, and you may very well be forced to stay in this market. It is interesting that India and China, two markets that restrict domestic investors from investing outside the country, are the two most richly priced.
As I confessed up front, I am not a China hand and don’t claim any macro or market forecasting skills, but my experience with company valuation and pricing lead me to make the following predictions for China.
- Slower real growth: If I were a betting man, I would be willing to take a wager that the expected real growth rate in the Chinese economy will be closer to 5% a year for the next decade than to the double-digit growth that we have been programmed to expect. That may strike you as pessimistic, after the growth of the last two decades, but just as size eventually catches up with companies, the Chinese economy is getting too big to grow at the rates of yesteryear. The question, for me, is not whether this will happen but how the Chinese government will deal with the lower growth. While the sensible option is to accept reality and plan for lower real growth, I fear that the need to maintain appearances will lead to a cooking of the economic books, in which case we will have an number-fixing scandal of monumental proportions.
- More pricing ahead: I don’t see much hope that investors will be welcomed back into Chinese markets any time soon. So, even if this market shakeup drives some of traders out of the game, investors motivated by value will be reluctant to step in, if the government continues to make markets into morality plays. As long as the market continues to be a pricing game, the price moves in the market will have little do with fundamentals. As a consequence, I would suggest that you ignore almost all attempts by market experts to explain what is happening in Chinese markets with economic stories.
- Buyer beware: If you are drawn to Chinese markets (like moths to a flame), here is my advice for what it is worth. If you are an investor, you need to look past the hype and value companies, opacity and complexity notwithstanding, and be a realist when it comes to corporate governance. If you are a trader, this is a momentum game and if you can get ahead of momentum shifts, you will make money. If your bet is on the downside, just be ready to be maligned, abused or worse.
I understand why corporate chieftains and heads of government are unwilling to speak openly about the Chinese government, given how much of their own economic prosperity rests on maintaining good relations. Financial markets don’t have such qualms and they are delivering their message to Beijing clearly and decisively. Let’s hope someone is listening!
- Industry-average PE and EV/EBITDA, by sector
- Chinese Company-level data, Multiples and Fundamentals