Monday, 3 December 2012

Shanghai’s disturbing stock slump

Commentary: A-shares’ valuation may offer reality check

By Craig Stephen
HONG KONG (MarketWatch) — The fall of Shanghai’s main share-market index below 2,000 points last week has put the frailty of China’s domestic stock markets back in the spotlight.
Clearly having the world’s second-largest economy counts for little when equity-market returns are added up. Once again, China’s stock markets look to be in the running for the title of the year’s worst-performing equity market — along with Slovakia and Spain.
The benchmark Shanghai Composite Index CN:000001 -1.03%  ended last week near four-year lows, having lost a total of 67% since its October 2007 record high.
The consolation, as various investment banks are quick to point out, means share-price valuations are cheap. The CSI 300 (the index designed to replicate the top 300 stocks traded in Shanghai and Shenzhen) is trading at a historically low forward-P/E of 9.2 times and a price-to-book of 1.3 times, according to Goldman Sachs.
Smart investors should position for a cyclical rebound that could be just around the corner, analysts say.
But this call is getting somewhat tired. China’s stock markets were cheap last year, and they’re cheaper still this year. They might also be even cheaper next year.
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A possible explanation is that the low valuations merely reflect reality — China’s stock markets provide capital to the wrong companies and badly serve minority interests.
This might not be a new observation, but it warrants another look after this latest slump in domestically listed shares.
What is making analysts sit up is that China’s A-shares are now trading at a discount to Hong Kong-listed H-shares.
This trend has become more pronounced in recent weeks, as H-shares in Hong Kong reacted positively to better economic data from China, while A-shares continued making new lows.
So why are mainland Chinese investors more bearish than those outside mainland China?
One possible answer is liquidity conditions: China’s domestic stock markets are still largely off-limits to overseas investors, so unlike those in Hong Kong, they are less likely to benefit from international liquidity flows.
Low deposit rates in Hong Kong also discourage leaving money sitting in the bank. In China, by contrast, interest rates are higher, and trust saving products offer another alternative to equity investing.
But differences in monetary conditions are only part of the story.
What also looks to be spooking mainland Chinese investors is an equity supply overhang.
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HSBC notes that the supply of listed equities in China has risen much faster than growth in demand deposits in the banking system in recent years. This suggests insufficient liquidity to support the stock market, they say.
And it could be about to get a lot worse if a planned avalanche of share placements and IPOs materialize.
According to data released by the China Securities Regulatory Commission (CSRC) on Nov. 22, there are over 800 IPO deals in the pipeline for A-shares.
This is equivalent to one-third of the 2,400 A-share companies. The CSRC also approved 554 billion yuan ($89 billion) worth of placements from 321 A-share companies, notes HSBC.
In most equity markets in a long-term bear slump, this would look comically ambitious.
But this is China’s state-led equity market, where the CSRC is the gate-keeper to mainly state-owned companies coming to list. How it balances equity issuance needs and market stability will be closely watched.
After the Lehman crisis, a temporary halt to new listings was introduced to try to revive the equity market. Instead, in many cases, banks were able to provide funding.
This time round could be different. Mainland Chinese banks themselves are facing funding constraints.
Meanwhile, industries such as life insurance have already reached debt-funding limits and now require equity raises to boost solvency. Ironically, their solvency is being damaged by low equity-market returns.
Something may have to give.
Investors will be hoping China does not follow the Japanese path, where near-bankrupt companies were kept afloat by deeply discounted share placements. This usually comes at the expense of minorities.
Noticeably in Goldman Sachs report, Japan and Korea had the only equity markets cheaper than China.
Meanwhile, China’s ambitious capital-raising plans are likely to fall heavily on retail investors. Professional investors only accounted for 15.6% of the A-share total market capitalization as of the end of 2011.
Retail investors have already been retreating. Active trading accounts have fallen to just 58% of investment in August this year from 82% a year earlier, according to HSBC.
Perhaps experience has taught these investors that cheap equity valuations only tell part of the story. Valuations can go up without a rise in the share price, after all, if earnings get diluted by new equity or falling profits.
HSBC calculates that profit growth for the CSI-300 non-financial companies has been negative year-on-year for the past three quarters.
Reviving interest in China’s listed companies will take more than just pointing to cheap prices.
 
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