- We reiterate our price targets for the HSCEI and HSML100 Index at 16,280 points and 9,005 points by end-2011 respectively, which represent a potential upside of over 23% from the market close as at 18 May 2011
- We highlight the four main reasons that we favour the China market
We think China offers limited downside risks for mid- to long-term investors. We have assigned a 4.5 stars – "Very Attractive" rating to the China market
- China remains the global growth powerhouse over the next decade while the 12th FYP stresses a more sustainable and balanced growth model
- International investors under-invest in China
- Earnings have hit a record high but the equity market still has a long way to go
- Large banks’ strong 1Q11 earnings bode well for the financials-heavy equity market
The China equity market represented by the Hang Seng Mainland 100 (HSML100) Index went up 2.2% (in HKD terms) in 2010 and was the second worst-performing market amongst the 19 markets we cover. The underperformance has continued since beginning of this year and the HSML100 index merely managed to gain 1.9% (in HKD terms, the same as below), lower than the global average (MSCI AC World up 4.1%) and the debt-stressed Europe market (Stoxx 600 up 7.6%).
We have noted down "policy risks" since our monthly update in December 2010 and the disappointing performance of Chinese equities since YTD has been largely in line with our expectation. Nonetheless, we have recently noticed a few favourable developments, partly attributed to the robust corporate results of Chinese companies in 2010 and likely a less aggressive policy tightening by 4Q11. These lead us to reiterate our strong call for this compelling market.
In this article, we first review our price targets for the China market, and then we suggest four reasons why investors should remain confident to its outlook.
Reiterate Our Price Targets
While most investors may favour the Hang Seng China Enterprise Index (HSCEI) as the benchmark for the Chinese equities listed in Hong Kong, we prefer the Hang Sang Mainland 100 Index (HSML100), which is a broader measure of Hong Kong listed Chinese companies – by including companies incorporated outside the mainland China like red-chips and privately-run enterprises in China. We think the HSML100 Index is more representative because giant companies like China Mobile and CNOOC which are included in the HSML100 Index are ineligible constituents of the HSCEI Index.
Nonetheless, because of its wide popularity amongst investors, we still provide a price target for the HSCEI Index at 16,280 points by the end-2011, which represents 26.5% potential gain as of 18 May 2011. Correspondingly, we expect the HSML100 Index to hit 9,005 points by end-2011, which implies a potential upside of 23.8%.
Chart 1: A 23% plus potential upside for Chinese equities by end-2011
Basically, we have adopted a slightly conservative approach by lowering the PE assumptions from 14.0X to 13.4X for the HSCEI and 14.5X to 14.0X for the HSML100, compared to five months ago when we made our calls for this year. This is to reflect the addition risks brought by higher oil prices and inflation. It is important to note that we maintain the same price targets as our earlier calls, because higher earnings estimates have counteracted the lower valuations.
During our recent meeting with clients, we have discovered that many of them are discouraged by the sideways China market over the past 20 months, losing patience and considering investing into other markets. We however strongly suggest them stay invested in China for four reasons:
Reason 1: China remains the global growth powerhouse
China’s economy has leaped a big step forward over the past 30 years. The country has overtaken Japan as the world’s second largest economy (in nominal terms) for the first time last year. While many commentaries describe China’s growth story as too good to be true and its growth engine may soon run out steam, the first quarter GDP and 12th Five Year Plan (12th FYP) gives us some assurance.
China’s economy expanded 9.7% year-on-year in the first quarter of 2011, beating the consensus of 9.4%. The world’s second largest economy remains one of the world’s fastest growing economies in spite of its huge size. While there may be a growth moderation due to a change in its growth model (as we will discuss below), we think a sharp slowdown is unlikely and its role as the global growth powerhouse may even strengthen over the next 10 years. According to the BRIC update published by Goldman Sachs, China’s contribution to the world’s GDP growth is expected to rise significantly from 15% during 2001 and 2010, and to 30% during 2011 to 2020. This suggests that the growth moderation will unlikely drag down its global importance.
12th FYP highlights a major growth transition
On top of this, we expect a structural reform in China which helps the country to adjust its growth model. Under the 12th Five Year Plan, which is a strategic blueprint laying out the country’s economic outlook in the next five years starting from 2011, China sets to transit from an export-led economy to a consumption-driven economy.
With a population of 1.3 billion, China indeed hasn’t unleashed its potential to be the world’s largest consumer. In fact, amongst China’s traditional three growth drivers, exports and fixed assets investment growths have dominated over consumer spending since its accession to the World Trade Organisation (WTO) in December 2001 (Table 1). Such divergence has brought down the role of consumption drastically over the past 30 years amid its rapid economic development (Chart 2). As at end-2009, final consumption merely accounted for 48% of its GDP, much less than that in advanced economies and Asian counterparts.
|Table 1: Retail sales growth has lagged behind the other two drivers
|Exports (in USD)
|Urban Fixed Assets Investment
|Retail Sale Values
|Source: Bloomberg and iFAST Compilations
The financial crisis in 2008 has speeded up the transition process. Recent economic indicators have pointed to a more balanced growth amongst the three drivers (Chart 3). Over the next few years, the rising income and the growing middle class – we expect to see the largest growth in this decade - will likely help spur domestic consumption. The 12th Five Year Plan has depicted that the policy focus sets to turns from growth quantity to growth quality.
On the other hand, we notice there is a repetitive pattern hidden in the China’s economic cycle. Except for uncontrollable crisis occurred during the 9th and 10th FYP, China’s GDP growth is likely to accelerate in the 2nd year of each FYP before moderating in the later years due to overheating (Chart 4). In our view, this is a reasonable observation because China remains primarily a planned economy. It generally takes a year or longer to have the plan effectively implemented in all addressed areas. Therefore, we think this and the next year will be a favourable growth spot for China. Investing in China is simply the best way to ride on its rapid economic expansion.
Chart 4: Favourable growth spot in the middle of each FYP
Reason 2: International investors under-invest in China
We think investors cannot afford to ignore China in their portfolios.
Having said that, China has transformed itself into a global economic powerhouse. However, its equity market is deeply underrepresented in the global landscape. As shown in Table 2, China shares 16.3% of the world’s GDP in 2010 when measured in Purchasing Power Parity (PPP) terms, and has contributed almost 30% of the global economic growth between 2000 and 2008. Nonetheless, China is only weighted by a tiny share of less than 3% in the MSCI AC World Index. The world’s equity market is still largely represented by the developed markets led by the US, Europe and Japan.
|Emerging Markets (Total)
|Russia and other CIS
|Developed Markets (Total)
|AC World Index (Total)/ World Economy
|Source: MSCI Barra (as of 31 Dec 2010), the Conference Board, Russell Investments, iFAST Compilations
*EU-15 includes Austria, Belgium, Germany, Denmark, Spain, Finland, France, United Kingdom, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Sweden.
The underrepresentation is partly attributed to the restricted nature of the China A-share market which represents over 70% of the China’s total equity market universe (Source: World Federation of Exchanges, as of August 2010). However, even though we take the A-share market into consideration, China’s adjusted weight would merely increase from 2.34% to 8.08%, while the developed market’s weight would drop slightly from 86.37% to 81.30%. China remains well under-representative in the global landscape.
In our view, international investors will increasingly include more Chinese equities into their investment portfolios as China’s capital market continues to develop. We also expect more Chinese companies become members of the Fortune Global 500 which is a yardstick for global industry leaders. Over the past five years, the number of Chinese companies in the list has jumped from 16 in 2005 to 46 in 2010 with three of them appearing in the top 10 list.
With its rising economic and financial importance, such disconnect are likely to narrow and we think Chinese equities warrant a meaningful place in investors’ portfolios.
Reason 3: Earnings Record High but the Market still has a Long Way to Go
While earnings for the two China benchmarks have hit a record high in 2010, both indices still have a long way to go from its record peak attained (HSCEI -36.9% HSML100 -32.6% from peak, as of 18 May 2011) in 2007 (Chart 5).
If we assume the market gives the same price to each earning (i.e. same PE ratios), then record high earnings should propel the equity market to a record high level. However, both benchmark indices have been moving sideways over the past 20 months detaching from the earnings growth. Such divergence represents a disconnection between the earnings growth and the equity market (Chart 6), leading to a PE contraction.
Valuation close to post-crisis low end
Meanwhile, the PE for the China market is the fourth lowest amongst our 19-global market coverage after Russia, Korea and Europe. As shown in Chart 6 and 7, valuations for both HSCEI and HSML100 index have been close to the historical low-end. Furthermore, China market has seen the largest earnings upgrade YTD in the region (Chart 8) as companies have reported better-than-expected earnings. Given such compelling valuation and the potential for more earnings upgrades, we think it represents a very good entry point for mid- to long-term investors.
Chart 8: Consensus EPS revisions in major Asian equity markets
Reason 4: Chinese banks’ strong 1Q11 earnings bode well for the equity market
|Table 3: Sector Composition (%)
|Source: Bloomberg and iFAST Compilations (as of 16 May 2011)
The underperformance of the Chinese equity market is largely attributed to Chinese financials. As shown in Table 3, both HSML 100 and HSCEI index are financials-heavy. Policy risks and tightening woes over the past two years have weighted on the financial stocks and hence the equity market.
On the flip side, Chinese banks have consistently reported strong earnings. After recording a huge profit growth of 33% in 2010, earnings in 1Q11 jumped at 38% on the back of margin expansion and growing asset size. In particular, the 4Q10 and 1Q11 reported results have revealed that banks will likely benefit substantially on rising interest rates - the PBOC started the interest rate-hike cycle in October 2010. Therefore, a strong net interest income (NII) growth that we have seen in the last two quarters may repeat in the next two quarters. This increases their earnings visibility for this year.
Meanwhile, Chinese banks are trading at less than 2X forward PB ratio. The consensus expects the earnings for the Big Four banks to grow 25.2% in 2011 on average. We think this is a very cheap valuation given their high ROE (return-on-equity) at 20%. In our view, the attractive valuation, stable business and growing earnings visibility of Chinese financials may bode well for the equity market.
Limited downside risks for mid- to long-term investors
Over the near term, inflationary fears may continue to dominate the market sentiment. However, the recent commodity price slumps will likely ease price pressures due to imported goods. In addition, falling domestic food prices led by vegetables suggests that the rising cycle of food prices since 2009 may have ended, thereby easing pressures from food CPI. Thus, we expect PBOC to slow down the rate hike frequency, which will likely support the ongoing re-ratings.
To conclude, we think the investment case for the China market remains compelling and offers limited downside risks for mid- to long-term investors. Against this backdrop, we have assigned a 4.5 stars – "Very Attractive" rating to the China market.
Our recommended China equity fund is:
Mirae Asset China Advantage Fund- Growth