Are Investors Overreacting To China's Risk Factors?
August 23, 2013
As fears of an economic slowdown and heightened shadow banking risks continue to deter investors from Chinese equities, we conducted a stress test on the market's earnings to see how much of investors' concerns has been priced into the market's valuations. Despite postulating extreme negative market conditions, the investment outlook for Chinese equities remains promising.
Author : Christy Ma
Are Investors Overreacting to China’s Risk Factors?
To incorporate slower long term economic growth, we lowered the Chinese equity market’s fair PE from 14X to 13X in mid-2012
Here, we take our analysis one step further and stress test the market’s earnings, to evaluate the market’s prospects should we see a large scale de-rating of earnings.
Our stress test illustrates that Chinese equities are still looking attractive if extreme negative scenarios do play out
We believe that Chinese equities have been unfairly penalised for economic slowdown and shadow banking risk factors
Chinese equities continue to lag behind this year, sustaining 4.7% declines year-to-date (as of 16 August 2013, in HKD terms). Despite its underperformance this year, with long term fundamentals remaining attractive, we have repeatedly urged investors to seize the opportunity in this market. In particular, even as we adopted a conservative stance in evaluating China, by lowering the market’s fair PE in mid-2012, the upside potential for the market was still full of luster.
Nonetheless, as fears of an economic slowdown and heightened shadow banking risks continue to flood news headlines, it is no wonder that investors continue to remain deterred from this market. Taking our analysis one step further, we attempt to factor in extreme scenarios of de-rating (downwards adjustment to earnings estimates), to evaluate possible outcomes should market and economic conditions worsen dramatically. We emphasise that the results of our stress test in this article do not represent our base case scenario; instead, we hope it serves to demonstrate how much of investors’ concerns has been priced into the market’s current valuations. In the end, after stress testing the market’s earnings, despite postulating extreme negative market conditions, the investment outlook for Chinese equities remains promising.
Slower Long Term Growth Priced In
In the second quarter, weak numbers for GDP, exports and PMI all confirmed suspicions that China’s economy was slowing. While some of these figures may have missed analyst estimates by miles, slower long term economic growth in China should be no surprise by now. In light of China’s plans for transforming its economy towards a more sustainable consumption-driven model, we expected growth to taper off to a slower rate and incorporated these expectations into our analysis by lowering the market’s fair PE from 14X to 13X in mid-2012. This was done because a lower level of long term growth implies that the high valuation levels seen in the past is no longer justified for our forecasts. The prospect of slower economic growth is even more prominent with the new leadership’s determination to focus on implementing reforms and rebalancing the economy, which will translate into short term pain for long term gain.
As we have noted previously, despite the downwards revision in the market’s fair PE, this market continues to boast a high upside potential, which is currently at 71% until end-2015 (as of 16 August 2013), making it the most attractive market under our coverage.
A Stress Test: What if Shadow Banking Problems Cause Earnings to De-Rate?
We placed an aggressive discount of 30% to the 2013 earnings estimates for certain sectors we believe would be relatively hard hit, should market conditions worsen. These include the consumer discretionary, energy, financials, industrials and materials sectors represented by the Hang Seng Mainland 100 Index. On the other hand, to simplify the test, we did not discount the earnings estimates for the rest of the sectors listed in Table 1, as these sectors will be less affected by an economic slowdown and shadow banking risks. As we can see in Table 1, with such large discounts, all discounted sectors see their earnings for this year contract year-on-year.
Table 1: Earnings Growth Stress Test
Earnings Adjustment (Discount)
Consensus Earnings Growth Estimate (2013)
Adjusted Earnings Growth Estimate (2013)
Overall Earnings Growth Estimate
Source: Bloomberg and iFAST Compilations
Data as of 16 August 2013
Investment Outlook Under Stress Test Scenario Still Attractive
Referring to Table 1, our stress test scenario assumes that earnings will contract by 4.2% this year, instead of growing by 10.5%, which is the current market consensus. While this represents an unrealistically pessimistic outlook for China, the key point to note here is that even if conditions were to worsen to this extent and earnings do contract, at current prices, investors are still getting a bargain. Referring to Chart 1, under the stress test scenario, the estimated PE for 2013 is still just at 10.7X (compared with the 9.2X under current market consensus), which represents a significant discount from the market’s fair PE of 13X. In fact, this still translates into an upside potential of 46% until end-2015 (as of 16 August 2013).
Chart 1: Estimated PE Under Stress Test Scenario
Stress Test Limitations
We should note here that the stress test results do not reflect our projected earnings for Chinese equities this year, nor is this our base case scenario. There are also some limitations to this exercise; for instance, given the natural linkages between sectors in the economy, it is highly unlikely that financial earnings could drop sharply by almost 18%, while sectors like consumer staples can still enjoy double digit growth rates. Nonetheless, what we can do is focus on the adjusted overall earnings estimate, which has effectively been discounted by 13% after the stress testing. By doing so, this exercise can illustrate that Chinese equities are still looking attractive if extreme negative scenarios do play out.
Are Investors Overreacting to China’s Risk Factors?
In conclusion, although our earnings adjustments should not be taken literally as estimates, it shows that despite hefty stress on earnings, valuations of Chinese equities still look depressed. Furthermore, with aggressive revisions to earnings (under our stress test) and a downwards adjustment to the market’s fair PE, the market still boasts a 46% upside potential until end-2015 (and of course we expect more, since the stress test scenario is not our expectations for the market). By considering extremely pessimistic or conservative evaluations of the Chinese equity markets, we can see just how much negativity has been priced into the market’s depressed valuations. While uncertainty over the economy’s outlook and the shadow banking problems may continue to add volatility to the markets, we believe that Chinese equities have been unfairly penalised for these risk factors. With attractive fundamentals, we maintain our optimistic view on the market and continue to assign it with a 5-star “Very Attractive” rating.
Christy Ma is a Senior Analyst of iFAST Financial (HK)Ltd. (SFC Licenced Representative, CE no.:AZC130)
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