For the first time the Party is prioritizing economic sustainability over speed of growth, and investors are starting to pick stocks based on the quality of their earnings. What’s more, valuations are still reasonable. So when will global investors cotton on?
At an annual parliamentary session of the National People’s Congress this March, President Xi Jinping acknowledged that China was transitioning its economy towards higher quality growth.
His statement signals a major shift in Communist Party policy from the past four decades that promises to have profound implications for global financial markets. International investors should take note.
Ever since Deng Xiaoping took the reins of power in 1978, the Party has prioritized economic growth at all costs, its primary purpose to lift an impoverished nation’s standard of living. Deng set in motion a process of urbanization and industrialization on an unprecedented scale.
Importantly, such quality is still fairly priced in China.
The expansion mission has surpassed all expectations. Today, China’s economy stands as the world’s second largest. Its gross domestic product multiplied 40 times from Deng’s day to the end of last year, versus less than seven times for the United States, according to International Monetary Fund data based on current prices.
To achieve its social prosperity goals, from the outset Chinese policymakers used the financial system to collect citizens’ deposits and lend monies to state-owned enterprises (SOEs) at favorable rates. This nurtured national champions, in turn providing gainful employment to vast numbers of people.
But profitability took a back seat, creating bloated and uncompetitive state-run industries in areas such as steel, cement and power. To compound matters, companies started binging on borrowing to meet high state-directed growth targets.
Data from the Institute of International Finance (IIF), Global Debt Monitor, shows that China’s total debt-to-gross domestic product (GDP) ratio has surged 75% since 2008 to stand at 296% by the end of last year. By comparison, the U.S. ratio has declined 10% over the same period.
The Party is readjusting its priorities. It aims to improve the nation’s fiscal position while providing dependable sources of retirement income for a population that is now both aging and shrinking. Quality in the financial system matters more than ever before.
Policymakers are attempting to steer the economy away from dependence on industrial manufacturing and exports towards sustainable growth powered by domestic consumption and service efficiency. While not all industries are feeling the impact yet, the change in direction is already visible in services segments such as internet technology, travel and health care. These are some of the things that people demand as they get richer, a consequence of China’s urbanization and rising middle class.
Expansion in services is driving earnings in the sector and presenting stock-pickers with opportunities to find companies with good long-term growth prospects. Industry leaders with durable earnings, competitive advantages and strong market shares are best-placed to benefit from state-directed growth.
Get ahead of the curve
Happily we’re seeing a growing appreciation of quality in the A-share market. Historically, this has been a volatile and momentum-driven market dominated by retail investors fixated on short-term growth. They have tended to favor small-cap stocks whose limited size typically enables them to grow more quickly.
But last year, large blue-chip stocks – those more closely tied to macroeconomic factors – on average saw a 20% rise in share price on the back of a 17% increase in average earnings per share, according to Bloomberg data. By contrast, small caps saw an average 23.5% decline in share price, even though their average earnings per share (EPS) also increased. It suggested that earnings quality is becoming a more important driver for investors, albeit as high valuations among small caps undergo readjustment.
Importantly, such quality is still fairly priced in China. The A-share market is trading at a price-earnings ratio of 17.7x – below the MSCI All Companies World Index (18.8x) and the MSCI USA Index (23.2x), Bloomberg data showed. While valuations rise if you strip out financial stocks, they still look reasonable in light of companies’ stronger earnings prospects.
We believe growth driven by a rising middle income population will continue to power local company earnings and valuations for years, particularly because China is still at the start of its economic recovery, in historical terms.
We anticipate more long-term institutional capital entering the market as policymakers crack down on share-price manipulation and A-shares are incrementally added to widely-tracked MSCI indices from this June.
Global institutions place heavy emphasis on fundamentals such as earnings and valuations and take account of corporate governance. In other words, they prioritize quality. This will raise the bar for domestic firms and create a more rational market in which investors back companies based on their fundamental strengths, not short-term prospects.
If domestic investors are starting to pay attention to quality in China now, imagine what some of these quality companies will be trading at by the time international investors cotton on? It might be beneficial to get ahead of the curve, while quality still comes at a fair price.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks may be enhanced in emerging markets countries.