Unpopular in China

While lower delegate numbers is disappointing for a conference organiser, it is music to the ears of a contrarian investor. Could China now finally be ripe for picking unloved companies? 

 

China´s $9.2 trillion economy has quickly grown to become the world’s second largest and is closing the gap to the US at $16.8 trillion. At the same time, the combined market capitalisation of Chinese equities is only $3.4 trillion and dwarfed by the US at $23.5 trillion. Seen in light of a population of 1.3 billion compared with 300 million Americans, the comparison is even more startling; Chinese equities are priced at $2,615 per capita while the US is at a staggering $78,333. 

 

More importantly for value investors, the Shanghai Composite index remains at less than half of its 2007 peak measured in local currency, making it one of the cheapest in the world – only rivalled by Russia.

 

While Chinese equities might seem cheap on the surface, investing in the country is not for the faint-hearted. The Chinese economy has been slowing since the financial crisis, something that has pushed investor sentiment and valuations to multi-year lows. Faced with lower demand for its goods overseas post-crisis, China cushioned the economic blow by pouring money into infrastructure, property and factory investments. The problem is that export demand has remained soft and domestic demand hasn’t been able to pick up the slack.

New wonders of the world

The investment projects have created some new wonders of the world. Brand new airport facilities, such as the $1.4 billion Shenzhen International Terminal, handle passenger flows with great efficiency supported by cutting edge data systems. Shenzhen is one of China’s top checkpoints for both passengers and cargo, much of which is a result of the rapid development in e-commerce. The city has developed into the main link between Hong Kong and mainland China and a logistics powerhouse; its impressive facilities, complete with automation and refrigeration, help explain why most internet purchases are delivered within 24 hours in the largest cities in China.

Elsewhere, a planned rail-line will mark the beginning of a New Silk Road with trains departing the city of Chongqing and traversing Kazakhstan, Russia, Belarus, and Poland before reaching Germany in 21 days, about half the time of a 40-day ocean freight and one-third cheaper than the price of air transit. Its successful delivery is unsurprisingly dependent on continued smooth relations between China and Russia, who are co-investors in several major freight forwarding service companies.

Ballooning debt

Premier Li Keqiang’s government is now walking a fine line. He has brought forward railway spending, cut some banks’ reserve requirements and reduced taxes. All to protect an annual growth target of about 7.5 percent. While economic expansion picked up to 7.5 percent in the April-June period from a year earlier, growth in the third and fourth quarters is set to dip back to 7.4 percent, according to median estimates in a recent survey of analysts.

Maintaining the growth rate has come at the expense of a ballooning level of corporate debt, particularly among state-owned enterprises as these firms have been deemed less risky by the banks.

During the quarter ending June 2014, the average debt-to-equity ratio for anything other than banks in the Hang Seng China Index increased to 61 percent, which is the highest level since the third quarter of 2009, less than two months before the end of the post-crisis rally. During the same three-month period, the combined free cash flow dwindled to negative $21 billion, the lowest level since the end of 2011.

Greater investor confidence in China will require policy makers to cut debt levels, reduce over-capacity and increase consumption to achieve sustainable economic growth.

For equity investors, searching for unloved investments in China is ultimately an exercise in thorough due diligence and having the patience to take a long-term perspective. As attendance at annual investor conferences goes up and down, the old adage still holds: it is better to enter into an unpopular investment than a popular one, which is about to become unpopular.