Vindicating the Investment Value of Chinese Stocks

Author: [Mu Zi]
Source: [Fund Analysis]
Article type: Regular article
Published: 2007-7-21 12:30:00
Column: Expert Perspectives

The investment value of Chinese stocks has been a perpetual target of suspicion since the day China's capital market was born. China's capital market — whether rising or falling — has been indiscriminately described by certain people as a place where junk stocks run rampant, speculative atmosphere is thick, and there is zero investment value. The most classic example has been the widespread acceptance of the "China's stock market is a casino" thesis. Even when the market fell below 1000 in 2005, there were still plenty of people wearing tinted glasses proclaiming that Chinese stocks had no investment value whatsoever. Obviously, for such people, even if China's stock market fell to 100 points, they would find countless reasons to declare Chinese stocks valueless.

Yet whether historically or in the present, severe speculative behavior exists in every capital market in the world. Without going far back, just look at the Hong Kong market. Among Asian markets, Hong Kong already has the lightest speculative atmosphere, yet its speculative behavior far exceeds that of the Shanghai and Shenzhen markets. I randomly picked HK1217 from among its junk stocks — the so-called "penny stocks" — as an example: this stock fell from HK$1.06 in 2003 to HK$0.011 in 2005, a decline of 99%. Last October, the stock was still at HK$0.022; by July of this year, its price had reached HK$1 — a gain of nearly 50 times in just over half a year. May I ask: among the so-called junk stock rally of the Shanghai-Shenzhen markets in the first half of 2007, which stock's movement could match this level of frenzy? Yet such movements are extremely common in Hong Kong.

As for European, American, and Japanese markets, speculation is equally present. Have Chinese market stocks gone from 20 cents to hundreds of yuan and then back to 60 cents? European and American and Japanese markets have such stocks. The claim that mature markets have less speculative behavior than emerging markets is completely contrary to fact. Speculation is an inherent feature of market existence. The more mature the market, the more avenues for speculation and the larger its scale. For example, investors familiar with the Shanghai-Shenzhen history know that Shenzhen has been more accustomed to speculative instruments like warrants, starting with the Bao'an warrants in the early 1990s, creating countless legends. The root cause is Shenzhen's influence from Hong Kong, and warrants are precisely one of Hong Kong's major speculative instruments — the speculative methods, history, and scale of which Shenzhen cannot compare. In fact, the speculative behavior in China's stock market can only be said to be below the average level of normal capital market mechanisms. China's capital market has never exhibited speculative phenomena above the average speculation level of any country or region.

Of course, we should aim for the highest standards and not emulate others' bad practices. So let us examine the investment value of constituent stocks, primarily blue chips. In all capital markets, P/E ratio assessments generally use constituent stocks as the benchmark. In the Hong Kong market, the P/E ratios of "penny stocks" are much higher than those of junk stocks in the Shanghai-Shenzhen markets. Saying Hong Kong's P/E ratios are low is only in reference to its blue chips and constituent stocks — the same applies to European, American, and Japanese markets.

In international markets, the most typical measure for evaluating a growth stock's investment value is not P/E ratio alone, but the PEG ratio — P/E ratio divided by average growth rate. Generally, as long as PEG < 1, the stock is considered reasonably priced. Currently, the average growth rate of the CSI 300 constituent stocks exceeds 50%. Therefore, in the Chinese stock market, a 50x P/E ratio is absolutely reasonable. Using an alternative calculation: since current interest rates are around 3%, a 33x P/E ratio implies parity with the interest rate level. With 50% growth, a stock at 50x P/E will see its P/E drop to 33x after one year — again confirming the reasonableness of a 50x P/E for Chinese stocks.

Nobody is God. Nobody can play God in dictating future stock prices. Stock prices are the resultant of various expectations, reflecting expectations about price. When the day comes that the average growth rate of Chinese companies declines, the acceptable P/E will naturally come down. Until that trend appears, the current foreseeable growth rate is of course the reference standard. It can be stated very clearly: after mid-year results are released, the average P/E of the CSI 300 will be far below 50x. The investment value of Shanghai-Shenzhen stocks is currently greatly underestimated.

On a larger scale, since China's current enterprises represent the future of China's economy, and since the historical trend of China becoming a world economic power is irreversible, some of the world's future largest companies will emerge from among the current listed companies. Chinese enterprises will also become multinational. Today, many Chinese listed companies — even the largest by market cap — from the perspective of becoming the world's biggest companies, can only be considered small-to-mid-caps; they are all growth stocks.

As long as one is bullish on the future of China's economy, there is no reason to lose confidence in Chinese companies. Who can say that the 21st century's greatest companies cannot be Chinese? Furthermore, it can be predicted with certainty: among the 21st century's 500 greatest companies worldwide, at least 100 will be Chinese. And these 100 companies are right there among the stocks currently trading on the Shanghai and Shenzhen exchanges.

(Special Senior Advisor to this publication, Mu Zi)