THE CHEAPEST COUNTRY IN THE REGION

May 2014 – For now, China appears to offer a similar opportunity to what Indonesia offered investors in the aftermath of the 1998 financial crisis

“I don’t know” are the most important words in investing.

No one knows what a stock will do tomorrow, next week, let alone next year. Analyse enough expert predictions and the conclusion is the same: the accuracy is slightly less than 50%, not much different from a coin flip. Last year’s top forecasters are rarely next year’s top forecasters, and three years in a row is unheard of.

This includes my own predictions. Investing is a game of probabilities. Sometimes the probabilities move sufficiently in an investors favour that action is warranted, assuming of course that one’s analysis of these probabilities proves to be correct.

A similar opportunity was available in the aftermath of the Asian crisis. An investor looking back at that period could easily conclude that late 1998 was the best time to buy stocks, as that was the absolute bottom in terms of price. However the real opportunity was more than four years later at the start of 2003, where despite a higher stock market the valuations were even cheaper. Taking Indonesia as an example of one of the worst affected countries from the crisis, in 2003 the country’s stock market was extremely unloved, having lost half of its value in the preceding six years, and was valued at less than 7x earnings while yielding more than 5%. This market went on to post in excess of 40% annualised gains over the next few years as valuations normalised, more than quadrupling in value.

Investing with hindsight is an easy thing to do. Are there opportunities similar to this now?

Keeping in mind that there’s around a 50% probability that I’m wrong, I’ll answer this question with a yes: China.

Like Indonesia in 2003, China equities are universally unloved, and are trading at less than 8x earnings, with a dividend of more than 4%. China equities have underperformed the S&P500 by more than 150% since the 2008 crisis, having posted annual losses every year after 2009. The losses continue this year, with the China stock market having lost -5% so far in 2014. This massive underperformance means that while the stock market price is slightly higher than the 2008-2009 bottom, the current valuation is significantly cheaper than at the bottom of the market, similar to our Indonesia example in 2003 vs 1998.

The reasons for this cheapness have been well documented: a slowing economy, bad demographics from the historical one-child policy, and a mountain of debt that is hidden off-book by many institutions. On top of all this the Chinese Yuan has recently been purposely weakened by the government to punish speculators. What else could go wrong? Current valuations price in an extremely hard landing which will require massive government bailouts.

What if China’s economy does not blow up? This is where the probabilities move in an investors’ favour. China has the lowest valuation in the region on every major valuation metric that can be used. And all this for a market that is expected to grow earnings both this year and next. The market is clearly pricing in a hard landing, but this is one of the rare occasions where the market could be wrong.

Looking under the hood of the overall Chinese market shows even more extreme under-valuations. Three sectors in particular rank at the top: Chinese property companies (3x earnings), Chinese banks (5x earnings), and Chinese infrastructure companies (5x earnings).

The cheapest of the sectors, China property developers, are also the highest risk as they have very high levels of leverage, and maybe even more debt hidden off balance sheet. It is up to the each investor to decide whether this risk is offset by a valuation at 3x earnings and individual stock dividend yields of 8%.

Large Chinese banks are trading at less than 5x earnings, with dividend yields of 7%. Markets fear a hard landing that would cause a surge in non-performing loans, as well as the banks being on the hook for ‘wealth management products’ sold to investors, a few of which have recently defaulted.

Finally infrastructure companies (railways, power companies, etc.) are also trading near 5x earnings, despite recent government announcements of railway stimulus packages that would strongly benefit the sector.

Just as the above sectors score highly on valuation metrics, not everything in China is cheap. Many stocks, particularly in technology and the casino sectors, have been strong recent performers and are trading at much higher multiples of 30x earnings.

Will Chinese equities over the next few years repeat the outperformance that Indonesia experienced after 2003? I don’t know.

Maybe China’s economy will collapse, and the stock market will continue to underperform as growth slows and earnings fall. Each investor should do their own analysis to decide whether the current valuations are already pricing in this dire economic outlook, and whether they are willing to take the risk that the China’s future will not be this negative.

By LEONARDO DRAGO

Co-founder of AL Wealth Partners, an independent Singapore-based company providing investment and fund management services to endowments and family offices, and wealth-advisory services to accredited individual investors.