Not long ago, just to ask the question would invite ridicule. But now, after the almost-halving of Chinese share prices so far in 2008, itâ€™s more than appropriate to ask, â€œAre Chinese company valuations too low?â€
My answer? Yes, they are too low.
According to the MSCI index, the current average PE ratio of all quoted Chinese companies is 16X, equal to Japanâ€™s, and lower than the 18X average for US-quoted companies. In other words, investors are willing to pay more, on average, for a companyâ€™s earnings stream in the US than in China. And yet, of course, profit growth in China is, on average much higher.
Itâ€™s not at all remarkable to find Chinese companies whose profits are growing by over 40% a year. In fact, among our clients at China First Capital, thatâ€™s the norm, rather than the exception. Some clientsâ€™ profits double year after year. Not very many, if any, Â US companies can match that rate of growth, for the simple reason that the overall US economy is stagnant, while Chinaâ€™s continues to roar along at a +10% growth rate. Corporate profits form a part of the calculation of gdp growth, and itâ€™s historically true that corporate profits just about everywhere grow faster than the underlying economy.
Thatâ€™s what makes the current PE valuation for China something of a conundrum. PE ratios are an expression, after all, of collective sentiment on the future rate of corporate profit growth. Clearly, Chinaâ€™s is now, and will likely remain for quite some time, higher than not only the USâ€™s, but the rest of the worldâ€™s. Â
Itâ€™s not hard to find good reasons for this steep drop in Chinese valuations this year. Bad news has come not as single spies, but as entire regiments in 2008. Natural disasters (the worst winter weather in 50 years, and then the horrific earthquake in Sichuan), the steady appreciation of the renminbi effecting Chinaâ€™s export competitiveness, the slowdown of the US economy, the end of pump-priming government spending in the run-up to the Olympics, the global rise in oil prices, and a near-doubling in inflation to +7% all contributed to investors loss of confidence, and with it, a decline in Chinaâ€™s share values.
But, this look like a classic case of a market overcorrecting. The decline in share prices, and with it Chinaâ€™s average PE ratio, certainly seem excessive. Â The fundamentals are still very solid for very many Chinese businesses. Corporate profits, though under pressure in China as elsewhere, can sustain themselves at very high rates of growth. Chinaâ€™s best companies are improving margins, improving efficiency, quality and productivity, and focusing on the fast-growing Chinese domestic market. Â In other words, good companies in China do exactly what the good ones in the US do â€“ get stronger and leaner when times get tougher.
It seems to me that valuations will rise again soon, maybe not to the dizzy heights of a year ago, but to a level reflecting this one fundamental truth â€“ nowhere else on the planet will corporate profits on a whole grow as fast, for as long into the future, as they will in China.Â