Investors should not wait too much longer before investing in China, where stocks are tremendously undervalued, argues Eastspring Investments, the Asian funds arm of UK insurer Prudential.
While this view is not new – the mainland has a number of bulls as well as numerous bears currently – the firm says most global investors appear to be missing the real story and may fail to spot a huge buying opportunity in the first half of the year.
Chinese company valuations are extremely low – as low as they were during the 2008/2009 financial crisis and after the Sars epidemic in 2002-2003 – says Robert Rountree, Singapore-based global strategist at Eastspring.
Moreover, high American corporate profits contradict the country's weak economic outlook. US earnings per share are higher than sales per share in the year to end 2013, according to the Institutional Brokers’ Estimate System (IBES), which is weighted against MSCI US and Asia ex-Japan indices. This is an indication that US companies are cutting costs and expanding share-buyback programmes and is not necessarily a sign of a true recovery, argues Rountree.
The opposite is true in Asia, he says. According to IBES numbers, sales per share exceed earnings per share in the region, indicating a return of confidence and rising demand, he says.
Yet investors continue to favour US stocks, a trend sparked last spring by then-Federal Reserve chairman Ben Bernanke’s comments that the Fed would soon taper its quantitative easing programme. That led to billions being yanked from emerging market equities over the summer and helped contribute to a 26% rise in the S&P 500 for 2013. It closed at 1,841 on December 31 and has since fallen back 4.7% to 1,755 as of February 4.
Some Eastspring funds are overweight several US banks, Rountree argues, but these stocks are not cheap, as the flight into US cyclicals has driven them to pre-crisis levels - and in some cases higher. As such, he argues the question investors should pose is whether the US recovery is actually strong enough as to justify these pre-crisis valuations.
“In other words, is the US economy as strong as it was in 2007?” he says. “Investors should ask themselves how strong is their belief in the US, particularly if they’re chasing growth and given how expensive growth stocks in the US are. How much are they willing to sacrifice before they get back into Asia?”
Rountree predicts a China rally in the second half of the year. “There’s still enough momentum in the US, [and investors] think they will still get something out of the more expensive cyclicals,” he says, citing US consumer discretionaries, materials and industrials. “But [US stocks] have never been this expensive. And at some point, investors will say, ‘We should take the profits [and] switch markets.’”
Still, there are reasons to be wary about investing in Chinese equities. Bears question the sustainability of continued post-crisis growth, which has been underpinned by easy credit. Hedge funds say short-selling opportunities include financial, property and materials-related stocks. And others say the country is spiralling towards a credit crisis.
Rountree acknowledges that China has a solvency problem, but argues it has been analysed extensively and discounted into prices. “China’s banks are valued on a variety of measures [and] are at the lows last seen at the peak of the 2008 crisis. When you look at the same sectors in China as in the US, you can see how much cheaper China is.”
Most agree that proposed Third Plenum reforms – which include price liberalisation, opening up to private and foreign competition, and state-owned enterprise reforms – will not be smooth. China’s shift from being an export-driven economy to one focused on consumption will hurt profits for a number of companies, says Rountree.
But many forget that China is no stranger to reforms, he notes. Utilities, telephone and airline industries all underwent restructurings, resulting in “similar bouts of fear and mis-pricing” – yet the country ultimately benefits, he says.
On US interest rates rising, Rountree does not expect a significant jump any time soon, noting that any hike will be very small. “It will be years before we see any meaningful rise in rates,” he says.