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Four Reasons Why We Remain Positive on the China Market
Malaysia Perspective | 23 June 2011

By The iFAST Research Team
The Chinese equity market represented by the Hang Seng Mainland 100 (HSML100) index went down 9.3% (in RM terms) in 2010 and was the second worst performing market among our coverage of 19 markets. The under performance has continued through 2011 thus far and the HSML100 index only managed to gain 1.0%, lower than the average of global markets (MSCI AC World index up 2.6%) and the debt-stressed Europe market (Stoxx 600 index up 6.7%) (all in RM terms year-to-date as of 18 May 2011).

The disappointing performance of Chinese equities year-to-date has been mostly in line with our expectations. Nonetheless, we have noticed a few favourable developments recently, partly attributed to the robust corporate results of Chinese companies in 2010 and the possibility of a less aggressive policy tightening in 2H 2011.

In this piece, we first review our price targets for the China market, and highlight four reasons why investors should remain positive on its outlook.

Reiterate Our Price Targets
While most investors may favour the Hang Seng China Enterprises Index (HSCEI) as the benchmark for Chinese equities listed in Hong Kong, we prefer the HSML100 index because it is a broader measure of Hong Kong-listed Chinese companies, as giant companies like China Mobile and China National Offshore Oil Corporation (CNOOC) which are included in the HSML100 index are ineligible constituents of the HSCEI.

Nonetheless, because of its popularity among investors, our price target for the HSCEI Index is 16,280 points by end-2011, which represents a 26.5% potential gain as of 18 May 2011. Also, we expect the HSML100 Index to hit 9,005 points by end-2011, which represents a 23.8% potential upside.

Chart 1

Source: Bloomberg and iFAST compilations

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 2011. This is due to additional risks brought about 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 offset the lower valuations.

We strongly suggest investors to stay invested and ‘overweight’ on China for four reasons:

Reason 1:China Remains The Global Growth Powerhouse
China has surpassed Japan as the world’s second largest economy for the first time last year. While many 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) FYP provided assurance.

China’s economy expanded 9.5% year-on-year in the first quarter, beating consensus estimate of 9.3%. It remains one of the world’s fastest growing economies despite its huge size. While there may be growth moderation due to a change in its growth model (more on that later on), 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% (from 2001 to 2010) to 30% (from 2011 to 2020). This suggests that its growth moderation is unlikely to drag down its global contribution.

Major Growth Transition
We expect that a structural reform in China will help the country adjust its growth model. Under the 12th FYP, China plans to transit from an export-led economy to a consumption-driven economy.
With a population of 1.3 billion, China hasn’t unleashed its potential of being the world’s largest consumer. In fact, among China’s three primary growth drivers (Chart 3), its exports and fixed asset investment growth have dominated 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. As at end-2009, final consumption merely accounted for 48% of its GDP (Chart 2), much less than that in advanced economies and Asian counterparts.

Table 1: Retail sales growth as lagged behind the other two drivers

Source: Bloomberg and iFAST compilations

Chart 2
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The financial crisis in 2008 has sped up the transition to a consumption-driven economy. Recent economic indicators have pointed to a more balanced growth among the three drivers (Chart 3). Over the next few years, the rising income and the growing middle class will likely help spur domestic consumption. The 12th FYP has depicted a shift in the focus of the policy from growth quantity to growth quality.

Chart 3
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Also worth noting, except for the Asian Financial Crisis in 1997 and SARS outbreak in 2002 during the 9th and 10th FYP, China’s GDP growth is likely to accelerate in the 2nd year of each 5-year period before moderating in the following 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 even longer to have the plan effectively implemented. Therefore, we think this year and next year will present a favorable growth spot for China. Investing in China is the best way to ride on its rapid economic expansion.

Chart 4

Source: Bloomberg and iFAST compilations

Reason 2:International Investors Are Under Invested In China
Although China has transformed itself into a global economic powerhouse, its equity market is deeply underrepresented in the global investment landscape. As shown in Table 2, China shared 16.3% of the world’s GDP in 2010 and has contributed almost 30% of the global economic growth from 2000 to 2008. Nonetheless, China’s weightage in the MSCI AC World index is a mere less-than-3%. The world’s equity market is still largely represented by the developed markets led by the US, Europe and Japan.

Table 2

Source: MSCI, The Conference Board, Russell Investments, iFAST compilations (as of 31 Dec 2010) N.B. EU-15 includes Austria, Belgium, Germany, Denmark, Spain, Finland, France, United Kingdom, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Sweden.

The under-representation is partly attributed to the restricted nature of the China’s 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 if we include the A share market, 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 under-represented in the global landscape.

In our view, international investors will increasingly include more Chinese equities into their investment portfolios as China’s capital market develops further. We also expect more Chinese companies to become members of the Fortune Global 500 list 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 3 of them appearing among the top 10.

With its rising economic and financial importance, such disparity is likely to shrink and we think Chinese equities warrant a meaningful place in investors’s portfolios.

Reason 3: Earnings Have Hit A Record High But The Equity Market Still Has A Long Way To Go
While earnings for the two China benchmarks have hit a record high in 2010, both indices are still a long way from its record peak (HSCEI -43.0% HSML100 -39.0% from peak, in RM terms as of 18 May 2011) in 2007 (Chart 5).

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’s trend. This divergence between the earnings growth and the equity market (Chart 6), resulted in a PE contraction.

Chart 6
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Valuation Near Post-Crisis Low-End
Meanwhile, PE for the China market is the fourth lowest among our coverage of 19 markets after Russia, Korea and Europe. As shown in Chart 6 and Chart 7, valuations for both HSCEI and HSML100 indices were close to the historical low-end. Furthermore, China market has seen the largest earnings upgrade in 2011 thus far in the region (Chart 8‌) as China companies have reported better-than-expected earnings. Given such compelling valuation and the potential for more earnings upgrades, we think that now is a very good entry point for mid- and long-term investors.

Chart 7
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Chart 8
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Reason 4: Large Banks With Strong Earnings In 1Q 2011 Are Expected To Drive The Financials-Heavy Equity Market

Table 3: Sector Composition (%)

Source: Bloomberg and iFAST compilations (as of 16 May 2011)

The under performance of the Chinese equity market is largely attributed to Chinese financials. As shown in Table 3, both HSML 100 and HSCEI indices are financials-heavy. Policy risks and tightening woes over the past two years have weighed down financial stocks and hence the broader 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 1Q 2011 jumped 38% on the back of margin expansion and growing asset size. In particular, the 4Q 2010 and 1Q 2011 results have revealed that banks are likely to benefit substantially from rising interest rates. People’s Bank of China (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 continue into 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 expection is that the earnings for the Big Four banks will grow 25.2% in 2011 on average. We think this is a very cheap valuation given their high ROE (return-on-equity) ratio of 20%. In our view, attractive valuation, stable business and increased earnings visibility may bode well for the equity market.
There are limited downside risks for mid- and long-term investors. Over the near-term, inflationary fears may continue to dominate market sentiment.

However, the recent commodity price slumps will likely ease pressure on prices of imported goods. In addition, decreasing prices in domestic food led by vegetables suggests that the rising cycle of food prices since 2009 may have ended, further easing pressures on food CPI. We expect the PBOC to slow down the rate hike frequency, which will likely support PE re-ratings by investors going forward.

To conclude, we think the investment case for the China market remains compelling, with limited downside risks for mid- and long-term investors. On that note, we have assigned a 4.5 stars “Very Attractive” rating for the China market.

* The Research Team is part of iFAST Capital Sdn. Bhd.


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