Two reasons to steer clear of Chinese stocks

Here are some things that we know. We know that long-term stock market returns are utterly unrelated to economic growth; instead, they are related to the price at which you buy your stake. Buy a market when it is cheap, and history tells us you will make good long term returns; buy a market when it is expensive, and history tells us you will not.

We also know that when a market is cheap, sentiment will be such that everyone will have a reason why it will stay cheap forever, and must be avoided at all cost. The clever investor is the one who ignores the noise and looks at the price.

This brings me to China – people keep telling me how cheap it is. Brian Dennehy of sent me a chart this week showing how the major markets have performed since October 2007. The S&P 500 is down 10% and the FTSE 100 is down about 11%. But the Shanghai Composite index is down a nasty 62%. China doesn’t look that good over a 20-year period either: the MSCI China Index started at 100 on December 31 1992; it is now at 59.

It is a story borne out if you look at short-term fund performance too. The best performers in the US market are up between 18 and 20% over the past year, while even the very best performer in the Chinese market – First State Greater China Growth – is up only just over 4%. Its runner-up, Baillie Gifford Greater China, is down 2%.

Dennehy points out that the Chinese market bears many of the hallmarks of a bear market hitting bottom. There is a consensus growing against it among foreigners – note Barron’s ‘Falling Star’ cover from July this year, explaining why low Chinese growth is bad news for stocks – and among locals. The number of new trading accounts being opened has fallen to 2008 levels, and trading volumes on both main markets (Shanghai and Shenzhen) dropped by 30% in the first half of this year.

Next up is the fact that its price/earnings ratio, “depending on who you believe”, is either at or near a record low,  somewhere between ten and 12 times and much where it was in 1995. Chinese stocks used to trade at a massive premium to those in the rest of Asia; now they trade on a discount. Dennehy isn’t alone in his enthusiasm. The idea that Chinese equities are historically cheap is gaining momentum: even Asia-based stock guru and über bear Marc Faber told me a few weeks ago that at these prices, China is due a major bounce.

Given that I am usually keen to push you into cheap equities (it is the only way to survive this kind of very low interest rate environment) you might now expect me to suggest that you start buying. But while I wouldn’t be at all surprised to see China rally nicely from these levels, it just doesn’t make sense as a long-term hold. Why? Two reasons.

First, it isn’t cheap enough. Very few valuation methods have ever shown themselves to be of any use in predicting where stock markets might go. The cyclically adjusted p/e ratio (Cape), however, does. And on Cape, China still looks expensive: cheap would be under 11 times, and China is on more like 16 times.

But the real argument against anyone but traders investing in the Chinese market isn’t really anything to do with the current price or with the various theories about how equities should or could be valued, or about the noise surrounding the political changes and economic slowdown.

Instead, as CLSA’s Russell Napier pointed out to me this week, it is about something more fundamental – the usual measures don’t hold good because the things listed on Chinese exchanges aren’t proper equities. An equity is a real share in an asset that you hope represents growth in the productive part of an economy – and a share that entitles you to all the rights that come with owning that asset.

But if you buy into a market such as China’s where the vast majority of shares are state-owned (about 80% of the market), that is not really what you are getting.

As one long-term China bear noted this week, “what is a Chinese bank but a branch of the Ministry of Finance which makes non-performing loans to state-owned companies, some of which are funded with equity sold to foreigners?” Quite. Own the Chinese market and you just don’t have the same kind of effective ownership as the word ‘equity’ suggests you should, something that surely makes most of our theories on valuation more or less irrelevant.

It is also worth noting that state control matters more than usual at the moment. Why? Inequality, the corruption that causes inequality, and the new focus on both in China.

In the West, if governments want corporates to distribute more of their profits to labour (which they surely do) they have to beg, legislate or take the money in taxes and redistribute it themselves. In China, the government (old and probably new too) can work to smooth things a little with a firm endorsement of fast-rising wages, something it can directly deliver via its ownership of the corporate sector regardless of whether the small pool of private shareholders agree with the policy or not.

That – obviously – suggests a state-sponsored squeeze on profit margins, says Napier. The other obvious risk to bear in mind is that the Chinese government probably doesn’t want to own most of the market forever, so we can surely expect it to sell parts of the various stakes it holds whenever prices rise.

As I’ve written before, in turbulent times you need to invest as far away from anything controlled by government as you can. Stocks owned by the state and listed in a command economy are too close to government for comfort.

• This article was first published in the Financial Times

  • Dyadco

    There is also another, perhaps more practical, reason to avoid Chinese equities: the quality of Chinese products is regarded as poor IN Asia !

    If you travel/live in SE Asia, you will find that the locals avoid buying Chinese goods. They regard them as poorly made and with no quality associated with their brands.

    This is enough to indicate to me to stay away.

  • BChung

    The irony is that they still buy Chinese Products because they couldnt afford the more expensive made in Japan, Korea, western brands, and they regard their own brands even poorer than Made in China or they simply couldn’t compete with Chinese Prices.

  • MG

    And of course the “western” banks are completely trustworthy, excellent investments…
    There is a BIG difference between Chinese equities listed in Shanghai/Shenzhen and those in HK. I believe Faber et al are referring to the Chinese enterprises listed in HK which are cheap, well managed companies with excellent prospects.
    People used to avaoid products made in Japan/Taiwan etc before they became established – I think you would be surprised just how much of the stuff you are buying is made in China – have alook at the labels. Not just big brands like Lenovo. I live in Asia and the quality is certainly not regarded as poor among my contemporaries. Frankly it’s a bit late to start knocking Chinese stocks, this is the time to start buying

  • Dyadco

    BChung, from my experience, this is not the case.

    Certainly in the SE Asian countries where I live, they are far more likely to buy their own products as they are better quality than the Chinese.

    MG, interesting that your contemporaries regard the Chinese goods as not being poor quality.

    I still won’t be buying Chinese stocks….as I feel there are much better opportunities in SE Asia.

  • market zone
  • How to Play the Stock Market Online

    What is the risk in the online stock market and how we handle these risks?

  • market zone

    plz introduce other reasons to steer clear of Chinese stocks.
    i want to know these reasons.

  • MG

    So the Chinese stock market is up about 5% since this call was made – best performing market in SE Asia…like I said, tell us something we don’t know