- The Chinese economy surprised to the upside and Chinese stocks have spiked.
- A fundamental analysis shows that Chinese stocks are still 50% undervalued.
- The Chinese economy is less risky and growing faster, but the market hasn’t yet fully recognized the situation which makes this the best time to invest.
One of the greatest fears circulating the investing environment in the last few years has been that China is about to slow down and drag the whole world into negative territory. I found such a fear a bit silly because it wasn’t based on proper macroeconomic analysis but mostly on western investors’ perception.
Western investors usually look at China and Asia through what’s going on in the developed world and expect the same to happen in Asia. This is the wrong way to look at things for one simple reason: Asian emerging markets have so much room to grow to reach developed countries that it is unlikely, given the easiness of technological and knowledge distribution today, for those countries to enter into a recession as long as they are still far from developed countries’ wealth levels.
Figure 1: China has still a lot of room to grow. Source: YRD.
I’ve written about the importance of being exposed to China a few times already in the past year to debunk fears around investing in China. You can read my macroeconomic analyses here, here, and here.
But something very important has changed this week. Chinese economic growth has surprised on the upside.
Chinese economic growth in Q2 2017 was 6.9%, thus higher than the expected 6.8%. The difference might seem minimal but for the general investing community, the trend is what matters.
Figure 2: Chinese economic growth has increased in speed in the last few quarters. Source: Trading Economics.
Thanks to such positive news in the last few quarters, investors’ sentiment toward China has changed and Chinese stocks have enjoyed a nice run in the last year and really spiked in the last week as the news of the Chinese economy beating expectations spread around the world.
Figure 3: Chinese ETF. Source: iShares.
When I see a 30% appreciation in anything, it’s always a good time to pause and reflect, analyze the situation, and see whether there is more room to grow or if the positions should be trimmed. In order to do that, today I’ll analyze Chinese stock fundamentals and macroeconomics alongside a comparison with global stock fundamentals.
Chinese Stock Fundamentals
The only reason why I like ETFs is because they offer me a great platform to do research. Thus I’ve checked the top 10 iShares MSCI China ETF holdings to assess the fundamentals of the Chinese market.
Figure 4: Chinese valuations are still extremely low. Source: iShares, Morningstar.
The analysis of the above table is simple. We either have companies with huge revenue growth or stable companies with high dividend yields. The average valuation for the growth companies is above 50 for Tencent and Alibaba, just 21 for NetEase, and 41 for Baidu. Given that those companies, except for BIDU, all show growth rates of over 50%, the valuations can still be considered very low. For example, Amazon’s revenue growth was 26% last year while its current P/E ratio is 188. Another comparison could be Facebook which had 54% revenue growth and has a P/E ratio of 40, and thus is in line with what the Chinese growth companies have.
As for the companies that practically show no growth, the valuations are extremely low. We have price earnings ratios around 6 for Chinese banks and around 13 for China Mobile and Ping Insurance which show some modest growth. Given that the S&P 500 boasts a P/E ratio of 26 for slower revenue and earnings growth, it’s easy to conclude that Chinese stocks are still undervalued and there is plenty of room for further growth.
We have an economy that is growing at almost 7% per year, a GDP level that is 7 times smaller then that of the U.S., and valuations that are half of what they are in the U.S. I could understand such a situation if the economic growth suddenly stopped and turned negative but given that the Chinese economy is growing faster, this all points toward extreme mis-pricing.
The good news is that the market has taken notice and Chinese stocks have gone up significantly in the last year, and especially last week. This is good because as the good news spreads around the world, more and more investors will get interested and the trend will most likely continue. Thus, we can conclude that the economic situation in China is getting less risky but the market hasn’t yet fully recognized the fact. Such situations are usually great investment opportunities.