27 October 2016
Technology and healthcare companies in China have seen robust earnings growth, making them good investment bets. Photo: Bloomberg
Technology and healthcare companies in China have seen robust earnings growth, making them good investment bets. Photo: Bloomberg

Hidden opportunities in China’s slowing economy

Despite an almost 50 percent slide from peak levels last June, valuations in China’s A-share market are still not cheap overall.

The Shanghai Composite index, for example, offers an aggregate price-earnings (PE) multiple of about 13. This is still 30 percent higher than the valuation prior to the market rally that began in August 2014, although earnings growth now is much weaker.

If the Chinese bank component (which trades at an average PE multiple of only 5.5) is excluded, the remainder of the Shanghai A-share market trades at a PE of 24. This is hardly cheap by international comparison. The PE of S&P 500 on Wall Street is only 18.

The Hang Seng China Enterprises Index trades at only 6 times PE.

No wonder there has been little foreign interest in buying A-shares via the Shanghai-Hong Kong Stock Connect facility.

However, this is not the way investors should look at Chinese stocks nowadays. Some interesting opportunities are emerging in the new economy sectors in technology as well as healthcare firms that are listed in Shenzhen.

While this theme is nothing new, the market’s cyclical implication is however different. These are growth firms in the new economy. Yet they had been punished by investors as if they were also like the structurally declining industrial firms in the old economy.

The nature of the A-share market has changed. It is no longer dominated by Shanghai. Five years ago, Shenzhen’s stock market capitalization was less than half of that of Shanghai. Now Shenzhen’s market is worth 18 trillion yuan, which amounts to 80 percent of that in Shanghai.

New economy plays, such as consumer goods, technology, healthcare and services firms, account for almost 55 percent of the Shenzhen Composite Index constituents, compared to only 23 percent for its Shanghai counterpart.

One may argue that Shenzhen stocks are expensive, with the key index trading at an average PE of 40 times. By comparison, the Nasdaq has an average PE of only 30.

So how does this make sense for buying into the “Chinese Nasdaq”?

In the end, it is a matter of relative comparison and earnings growth outlook.

Chinese healthcare and technology stocks have average PE ratios of 41 and 50, respectively, which makes them 5 percent and 20 percent, respectively, above their pre-rally valuation levels. However, the overall A-share market’s PE is still 43 percent dearer than its pre-rally valuation.

Prices of technology and healthcare stocks have fallen in lockstep with other A-shares. However, their earnings have grown much faster than the old economy companies.

For example, the combined profits of the energy and materials sectors fell by 70 percent in 2015. But the profits of technology and healthcare companies rose by an average of 49 percent in the same period.

For the first time, listed technology and healthcare firms have recorded larger profits than energy and materials companies.

So these new economy stocks are, in fact, much cheaper than the rest of the A-share market. However, by international comparison, they are still not that cheap for bargain hunters.

A crucial point to note is that stock valuation is all about the companies’ future. China’s new economy stocks are expensive for a good reason: growth.

High-growth firms are inherently difficult to value due to the fact that valuation models need to make arbitrary assumptions for the firms’ future growth rates.

It is not difficult to imagine that the growth outlook for the new economy sectors is going to be more robust than the old economy segments.

When the dust settles in the Chinese stock market, demand for new economy plays is likely to grow rapidly as investors realize that the growth stocks had been sold indiscriminately along with the old economy firms.

Even in the absence of a broad market rally, they could eventually outperform the benchmarks.

There is a caveat to this assessment though, and that is the uncertainty about China’s macroeconomic outlook and the renminbi’s volatility. These two factors can affect investor sentiment and keep A-shares on their toes, regardless of whether they are old or new economy plays.

But this uncertainty is unlikely to last forever. Meanwhile, it should be increasingly easy for foreign investors, including those from Hong Kong, to access China’s new economy stocks, especially those in the technology and healthcare sectors.

The Shenzhen-Hong Kong Stock Connect program is expected to be launched in the second half of this year. When implemented, this arrangement should allow international investors to trade Shenzhen stocks without going through the Qualified Foreign Institutional Investor (QFII) and the Renminbi Qualified Foreign Institutional Investor (RQFII) quotas.

If regulators use the Shenzhen 300 index as a basis for implementing the Shenzhen-Hong Kong Stock Connect, there will be 103 technology and healthcare stocks available for foreign access.

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Senior economist of BNP Paribas Investment Partners (Asia) Ltd. and author of “China’s Impossible Trinity – The Structural Challenges to the Chinese Dream”

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