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Back Issues
| Bubble: what bubble? | | Print | |
| May / June 2008 | |
 A recent survey of Chinese A-Share investors found that 70 percent believed they were investing in a bubble, matching the perception of most foreign observers.  The A-Share market (which is the domestic Chinese market) has in the past seven months been trading at the extremely high multiple of 70 times earnings.With recent reports that claimed 30 percent of those earnings came from investment income (read stock trading), suggestions that accounting practices were questionable and the threat of US$1.3 trillion of previously non-tradable shares becoming unlocked in the next two years, and it is no wonder that the A-Share market is now 25 percent off its previous highs. So is this correction just the first leg of the great unwinding? Not likely. In fact, it's' hard to find evidence of a bubble at all. Take valuations: the CSI 300 (a combination of Shanghai and Shenzen indices) is now trading at 20 times 2008 earnings forecasts; not cheap, but far from what we think of as a bubble valuation and way below its 10 year average of 30 times earnings. Why did this correction occur? First, bearish commentators were focusing on the smaller but more expensive Shenzhen market and looking backwards 12 months when share prices were growing at around 50 percent. Secondly, earnings grew 48 percent in 2007 and consensus is forecasting around 30 percent earnings growth this year. While 30 percent earnings growth seems like an aggressive number given the global slowdown, it may be achievable with a midteens nominal GDP growth rate - particularly when banks, oil and commodities are the main drivers. And what of all that so-called investment income, (which would presumably be turning into losses about now)? In fact, the 30 percent figure is completely misleading as ‘investment income' contains all operating income from JVs and associates. Stripping those out, we found that only 9 percent of non-financials income was generated by some form of asset revaluation which means the companies are generating higher quality earnings than is currently acknowledged. How much can we trust these numbers? Over 70 percent of the CSI 300 market cap is now audited by the Big 4 accounting firms using IFRS: the risk of accounting misadventures is now no higher than other emerging markets. The final issue ostensibly dooming the A-Share market is the unlocking of the Non-Tradable Shares and the threat that the current holders of such shares will flood the market with supply. Yet a quick glance at the A shares that have been unlocked since 2006 show that only 10 percent were actually sold into the market. In fact, over 75 percent of the shares being unlocked belong to the government. That they would be sold down en masse is highly unlikely. A much more likely scenario is the one that the government itself gives - that it will control the issuance of supply to continue to foster a healthily developing market. Indeed, the increase of share supply is critical for a sustainable market. A-Shares have historically traded at high valuations because China's ratio of Free Float market cap to both GDP and savings (i.e. the ratio of stock available for investors) remains far below other emerging and developed countries. In other words, there is not enough ‘supply' of shares relative to high ‘demand' from savers (especially given today's negative real interest rates). Both supply of and demand for shares are likely to rise rapidly in coming years, inevitably resulting in high volatility. Does any of this matter for international investors? With 72 percent of the market cap of the MSCI China already dual listed in Hong Kong and Shanghai (and the percentages rising monthly) the answer is yes. Hong Kong investors already closely watch the share price movements of the listed A Shares and the recent correction in the A-Shares market has been a major cause of the MSCI China's underperformance relative to other emerging markets. We are starting to see a correlation between the Shanghai and Hong Kong share markets because of: the rising weighting of China shares within the Hong Kong market and the increased number of dual listed stocks and the prospect of Chinese money coming into Hong Kong and playing the arbitrage between the two markets. While the A-share market may not yet be at a bottom, investors betting on a bubble unwinding should think twice. *Jake Lynch is Chief Representative of Macquarie Capital Securities Shanghai
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