China Stock Valuations: Are Chinese Shares Cheap?

Had a few big incoming questions on the Pebble Slack this week, starting bright and early on Monday with a thorny one:

Are Chinese stocks cheap?

It is an interesting as well as difficult question. On the one hand they have sold off steadily and underperformed Western and global markets. Contrarian investors might be forgiven for starting to view them with an open mind.

One the other, this cheapness is pretty understandable! As we have written before China is hammering its own companies and in the process decoupling from the global financial system.

In China right now, you have a very powerful government that is actively cracking down on some of the fastest growing parts of their economy and doing so with little to no opposition.

Tutoring companies, ride hailing companies, e-commerce giants, delivery apps, social media platforms, gambling concerns and even medical and plastic surgery companies have all been scrutinized, criticized and, in some cases, simply regulated out of existence.

What would Benjamin Graham - father of value investing and legendary inventor of fundamental stock analysis - say?

Well, the crackdowns have destroyed a lot of value but also created the possibility for a real opportunity. The only issue with this narrative is that valuations are not THAT cheap.

At the time of writing, the MSCI China Index is priced at around 15 times consensus earnings estimate. This is still very near the top of the 10 year range and while demonstrably cheaper than the US (or other developed markets) the political risk has re-emphasized why there is generally a discount for emerging markets.

Here are the forward price/earnings ratios of mainland Chinese stocks, Hong Kong shares and an index of US-listed Chinese groups, along with the 10-year average valuations of each (the dotted lines):

So, recent price action has been bad but China is not yet cheap. And stepping in front of the Chinese state's current campaign might be far worse than the usual freight train metaphors.

There are individual stock exceptions. Previous market darlings such as Alibaba and Tencent are at the bottom of their 5 year range.

Here are Chinese tech giants vs their American peers:

The best conclusion might be that Chinese shares are cheap vs their emerging market counterparts.

What to do about this?

"Stay away" or "Not yet" might be one way to summarize things.

Another way might be to play Chinese growth via wider EM markets minus China (you can buy EM ETFs WITHOUT Chinese stocks in them). Then you get the higher growth without all the political risk and extreme volatility from a government that clearly does not care if investors do not buy their country's stocks and money flows out of the country.

Yes, this is likely why EM ETFs are already doing rather well even as Chinese markets continue to head lower. However, this also means you do not need to worry about the latest decision in the CCP's Politburo on your portfolio.

China's decoupling continues.....


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