That said, broad-based A-share indices’ price to earnings ratios have also recovered to their post G-share peaks, indicating little upside from expansion of PE ratios and implying that investors will have to find higher growth companies in order to reap gains from share price appreciation.
Looking at things broad-brush, A-share prices are high relative to other stocks in the region. From a price to earnings growth perspective, A-shares appear cheap but this largely reflects average one-year growth estimates of 28% from local brokerages. If you believe those numbers that’s your business but even if the general trend is about right, there will be lots of over- and under-shooting of these forecasts.
This means that intrepid fund managers will have to get out of the office to put to work the widows’ and orphans’ money with which they have been entrusted.
A number of analysts have noted that the performance of China’s A-share indices has no discernable relationship with the country’s robust GDP growth. Mid-year earnings reports have all been filed so let’s take stock – so to speak – on how A-share companies are doing.
Profitability picked up in second quarter to an annualized 10% in first half 2006, versus 6.8% in 2001. While this is encouraging news, some stockbrokers indicate that the acceleration may in fact reflect slowing deterioration in steel, oil refining, and airlines rather than a broader improvement in profitability. Rising gross margins were bolstered by expanding sales growth which increased the ratio of sales to assets, a key determinant of ROE. Given the seasonality of most Chinese businesses, the trend should strengthen through year-end.
While sales have grown and operating margins have risen, second quarter ROE rose also in part on the back of increasing leverage, as companies have shifted to commercial paper (CP) from bank debt. CP offers lower interest rates than bank debt but the short tenor (30-180 days) imposes a near-term liquidity risk not encountered with bank borrowings.
Shifting to commercial paper feels good at the time but if liquidity in the CP market falls, there may be a repayment risk in at least some borrowers. Thus, many companies are enhancing ROE through increasing leverage even as debt payments as a percentage of cash flows fall.
Against this backdrop of general market recovery, our portfolio has fared about in line. Fund stalwart Baosteel 600019 was on course for a strong month but for a last minute blip that left it only marginally up, closing at RMB4.26.
The story was the same for Huaxia Bank 600015, whose share price we expected to play catch-up with the other listed banks. It seemed to be doing this, closing at RMB4.69 on October 16, only to sink to RMB4.54 by our cut off point the following day. Bank of China 601988 still lags, coming in at RMB3.33. Although it has climbed back up a bit recently, it has had a bumpy ride which we believe means share price weakness ahead.
Stick with steel
Baosteel is a large-cap actively traded stock; its liquidity gives us flexibility – i.e., we can always get out – and also gives the Fund exposure to China’s manufacturing sector. Accordingly, we let the bet ride with Baosteel.
Huaxia Bank in our opinion can go further, especially as some brokers are pushing China’s financial sector.
Bank of China’s A-shares still trade below the H-share price and both issues are underperforming their respective indices. The bank’s stock is still trading at above our purchase price of RMB3.28, so let’s sell out and take what little profit there is – before even that fades away!
We’ll replace it with Yili 600887, the Inner Mongolian dairy giant that has come off recent highs but still operates a solid business. As we all know, most Chinese don’t like dairy – except someone forgot to tell the Chinese, who have been picking up dairy products across most age groups.
We’ll take 300 shares of Yili at RMB20-odd per share, using up all the proceeds of the Bank of China sale and dipping just a bit into our cash pile.