Investigating China’s Stock Market


China, already a force in the global economy and the world political power structure, is about to become a major presence in worldwide equity investing as well. China is increasingly opening up its mainland stock markets to foreign investors, who until recently have been limited largely to Chinese companies listed on the Hong Kong Stock Exchange. That option remains open, but many investors are eager to dig into the heretofore hard-to-reach stocks in Shanghai and Shenzhen. In recognition of the opening of the mainland, or A-shares, market and in an effort to better reflect the global opportunity set, major index providers are adding, or are planning to add, stocks from these markets to their headline indexes.

[ecko_annotated header=”” annotation=”1. The company counts referred to throughout this post refer to MarketGrader’s coverage as of June 10, 2015, not the absolute total number of listings in any given country or exchange. MarketGrader’s coverage of Chinese equities (by domicile) exceeds 90% of all active issues, per FactSet. Typically, companies that are not covered and graded by MarketGrader Research lack a history of reported audited financial statements sufficient to perform a complete analysis.”]Understanding investors’ growing needs for research, analysis and investment insight on mainland equities, a market that now ranks second in the world by market capitalization, MarketGrader has been incorporating the A-shares universe into its soon-to-launch Global Research platform. Of the 35,312 companies around the world currently under MarketGrader’s microscope, there are 2,546 A-Shares and 482 China-domiciled Hong Kong-listed stocks1. Based on this (growing) wealth of fundamental bottom-up research, in April, MarketGrader introduced 18 International and Global Indexes, including two A-shares offerings, the MarketGrader China A-Share 100 and MarketGrader China A-Share 200. In selecting index components, MarketGrader assesses and grades companies in a given coverage universe based on a proprietary blend of 24 financial indicators measuring growth, value, cash flow and profitability. The highest grades go to companies that are financially strong, have demonstrated persistent growth and whose shares are priced attractively—essentially the “growth at a reasonable price” investment strategy. Its top-scoring U.S. companies make up the Barron’s 400 Index, which regularly outperforms mainstream benchmarks such as the S&P 500.[/ecko_annotated]

The same methodology used to create and maintain the Barron’s 400 was applied to the new international indexes. Like the Barron’s 400, the new indexes have minimum size and liquidity requirements for components, are equally weighted and are reconstituted semi-annually to ensure only companies with the highest grades are included.

[ecko_annotated header=”” annotation=”2. Based on MarketGrader’s Hong Kong Stock Exchange coverage.”]There are three exchanges with significant listings of stocks whose companies are domiciled in China. The Hong Kong Stock Exchange trades the stocks that were first allowed by the Chinese government to have public ownership. The 482 China-domiciled stocks covered by MarketGrader constitute 31% of Hong Kong listings2. This subset is used throughout this analysis. China’s mainland exchanges, the Shanghai Stock Exchange and the Shenzhen Stock Exchange, are bigger. Market capitalization comparisons are shown in Figure 1.[/ecko_annotated]

Figure 1. Market Capitalization of Exchanges with Chinese Stock Listings, Year Ended June 1, 2015
*China-domiciled listings only. Source: FactSet, MarketGrader Research coverage universe

It is important to note that there are two parts to the Shenzhen Exchange, which is the lesser known mainland exchange (for foreigners at least) containing a higher proportion of relatively smaller and newer private companies than the large, debt-laden and slower growing state owned enterprises (SOEs) more commonly listed in Shanghai. The first consists of regular listings, of which there are 1,162. The second is called China Next, or ChiNext, which was formed to attract innovative and fast-growing enterprises, especially high-tech firms, with less-stringent listing standards. One can think of it as mainland’s Nasdaq. As of June 1, 2015, there were 445 ChiNext listings covered by MarketGrader. Their average and median market caps were US $2.2 billion and US $1.6 billion respectively. Because of the difference in listing requirements, from this point forward our analysis will treat ChiNext as a distinct trading venue.

Figure 2. Two Parts of the Shenzhen Stock Exchange, Percentage of Total Listings

[visualizer id=”2624″]
Source: FactSet, MarketGrader Research coverage universe

Each of these stock markets has its “personality.” Stock size is one aspect of that and sector composition, by market capitalization, is another. For example, more than half the covered Hong Kong listings of China-domiciled companies are in financials, while that sector at ChiNext has a weight of only 1%. Industrials constitute roughly 30% of all the markets except Hong Kong, where the presence is 11%. Energy is 13% of Hong Kong but only 1% to 3% elsewhere. The sector variations of the four markets are detailed in Figure 3.

Figure 3. Sector Composition of the Chinese Stock Markets, by Market Capitalization[ecko_columns][ecko_columns_left]

China-Domiciled Companies Listed on the
Hong Kong Stock Exchange

[visualizer id=”2607″][/ecko_columns_left][ecko_columns_right]

China Next Listings on the
Shenzhen Stock Exchange

[visualizer id=”2608″][/ecko_columns_right][/ecko_columns]

Regular Listings on the
Shenzhen Stock Exchange

[visualizer id=”2609″][/ecko_columns_left][ecko_columns_right]

Listings on the
Shanghai Stock Exchange

[visualizer id=”2610″][/ecko_columns_right][/ecko_columns]
Source: FactSet, MarketGrader Research coverage universe

China’s stock markets are notoriously volatile; the recent advance of the mainland markets has been no different. The Wall Street Journal noted that the Shanghai market has lost or gained more than 3% in a single session nearly a dozen times in 2015 through the end of May; on May 28, Shanghai shares dropped 6.5%. Volatility has continued more recently; in the week ended June 19th, shares fell 13.3% and 12.7% in Shanghai and Shenzhen, respectively, leaving many gloomy on what may come. This turbulence has occurred in what has been an overarching upsurge in Chinese stocks that has lasted for more than a year. Figure 4 shows the staggering gains that occurred over the recent 12-month period through June 1, 2015.

Figure 4. Price Gains of Chinese Stocks in the Year Ended June 1, 2015

[visualizer id=”2539″]

*China-domiciled listings only. Source: FactSet, MarketGrader Research coverage universe

Of course, some sectors lead while others lag in producing the overall market averages. Figure 5 shows the details, but some caution is in order. First, the four charts are not visually comparable because the percentage scales had to be different to accommodate the data. Second, the Hong Kong chart is the only one with a scale that goes negative, highlighting the strength and breadth of recent momentum buying. Chinese-domiciled energy stocks, which have an important presence on that exchange, fell 16% on average during the year ended June 1, 2015; the median drop was 9%.

Figure 5. Sector Performance in Chinese Markets in the Year Ended June 1, 2015[ecko_columns][ecko_columns_left]

China-Domiciled Companies Listed on the
Hong Kong Stock Exchange

[visualizer id=”2634″][/ecko_columns_left][ecko_columns_right]

China Next Listings on the
Shenzhen Stock Exchange

[visualizer id=”2641″][/ecko_columns_right][/ecko_columns]

Regular Listings on the
Shenzhen Stock Exchange

[visualizer id=”2642″][/ecko_columns_left][ecko_columns_right]

Listings on the
Shanghai Stock Exchange

[visualizer id=”2643″][/ecko_columns_right][/ecko_columns]
Source: FactSet, MarketGrader Research coverage universe

Sectors in Shenzhen and its ChiNext segment did the best overall, followed by Shanghai and Hong Kong. And that stellar performance of financials in ChiNext came from just one stock.

When prices soar that high that fast there usually are consequences. For one thing, the price-earnings ratios jump higher, especially if the calculation uses already-reported earnings. According to investor basics, high PE ratios signal an overpriced condition, which means “don’t buy” because achieving “reasonable” pricing would require prices to fall. But it is obvious from Figure 6 that Chinese investors—particularly on the mainland—appear to pay little or no heed.

Figure 6. Change in PE Ratios of Chinese Stocks Over One Year

6/1/2015 Trailing PE 6/1/2014 Trailing PE Pct. Chg in Trailing PE
Average Median Average Median Average Median
Hong Kong* 19 15 13 10 45.78% 53.18%
Shenzhen (Regular) 172 83 60 33 37.23% 153.27%
Shenzhen (ChiNext) 267 164 91 54 192.08% 201.83%
Shanghai 136 63 56 25 141.77% 153.74%

*China-domiciled listings only. † Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

Concomitantly, MarketGrader’s financial-strength scores usually fall following price surges because the stocks no longer get high grades on value. Grade erosion is indeed apparent in Figure 7, but not remotely to the same degree as the price increases. In the MarketGrader system that can only mean that grades on other measurements such as growth, profits and cash flow improved sufficiently to compensate. In this light, note the sole exception to the grade erosion.

Figure 7. Change in MarketGrader Scores of Chinese Stocks Over One Year

6/1/2015 MG Score 6/1/2014 MG Score Pct. Change in Score
Average Median Average Median Average Median
Hong Kong* 44 45 48 49 -7.05% -8.47%
Shenzhen (Regular) 37 36 40 38 -6.41% -5.07%
Shenzhen (ChiNext) 43 44 42 43 1.07% 2.28%
Shanghai 35 35 38 36 -7.50% -4.65%

*China-domiciled listings only. † Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

ChiNext, the market that zoomed the highest in the year ended June 1, 2015, was the only one to have its average and median MarketGrader scores rise. That says a lot about the smaller, go-getter companies that list on ChiNext. It also bodes well for the growth of China’s private sector economy, which is of central importance to the structural economic rebalancing articulated at Xi Jinping’s Third Plenum, as it continues to move from infrastructure investment- and export-led growth to a free market orientation fueled by increased consumption, private sector innovation and higher value-added manufacturing.

All of which raises the question, how did the Chinese companies do in basic fundamentals during the year studied? The short answer is “good but not great (except for ChiNext), and the long answer is detailed in Figure 8.

Figure 8. Fundamental Performance of Chinese Stocks Over One Year

Percent Change
Hong Kong* Average Median
   Sales 11.81 5.81
   Operating Income 24.93 2.24
   Net Income 85.81 2.73
     *China-domiciled listings only.
Shenzhen (Regular)
   Sales 18.62 7.97
   Operating Income 10.81 3.31
   Net Income 72.96 3.85
Shenzhen (ChiNext)
   Sales 30.63 22.55
   Operating Income 58.56 14.61
   Net Income -28.43 14.97
   Sales 18.75 3.92
   Operating Income 157.34 -1.24
   Net Income 175.17 1.03

† Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

The low medians everywhere but ChiNext indicate some very outsized gains were responsible for the jump in the averages. In Shanghai, for example, the operating income median is slightly negative but the average increase is a stunning 157%. The disparity is even wider for net income. This means plenty of Chinese companies are encountering rough seas in their quest for success and prosperity—even as their stocks ride the coattails of the top-performing companies. The negative net income average for ChiNext probably is due in large part to the depreciation associated with asset building by young, growing companies. Their gain in operating income certainly is substantial.

Indeed, asset expansion seems to be a key theme among Chinese companies. The ratio of price to book value generally rose far more modestly during our study year than skyrocketing stock prices. This indicates considerable asset growth, albeit not to the extent of stock-price inflation. It is worth noting that assets can “grow” not only by adding factories, equipment, etc. but also by reducing debt and thereby the liabilities subtracted from the assets to produce “book value.” Such debt reduction is important to Beijing’s calculation that the market rally and recently reduced interest rates can assuage debt burdens.

Figure 9 has the details.

Figure 9. Change in Chinese Companies’ PB Ratio Over One Year

6/1/2015 PB Ratio 6/1/2014 PB Ratio Pct. Chg. in PB Ratio
Average Median Average Median Average Median
Hong Kong* 2 1 2 1 0.00% 0.00%
Shenzhen (Regular) 6 4 5 3 23.20% 38.64%
Shenzhen (ChiNext) 7 6 6 4 27.79% 36.43%
Shanghai 10 4 -10 2 100.00% 57.26%

*China-domiciled listings only. † Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

Price to book ratios, though, may be somewhat deceiving, especially since they tend to be in the single or low double digits. While a median price to book ratio of 6 for ChiNext stocks seems tamer than a median price to earnings ratio of 164, they both underscore the same point: that Chinese stocks are far from cheap.

A complementary way to look at Chinese company fundamentals when considering valuations is the change in shareholder equity over a given period of time. Since shareholder equity accounts for debt (i.e. assets minus liabilities), it is perhaps the purest form of shareholder value—and ultimately ownership—in a productive enterprise. An added advantage of measuring changes in shareholder equity lies in the fact that debt, regardless of how efficiently a company puts capital to work, goes against shareholder equity gains, something that doesn’t show up in the growth in sales or earnings. (More on debt levels later)

To be sure, during our study year, Chinese companies’ shareholder equity values, in the aggregate, have indeed expanded handsomely. In fact, the entire universe of companies described above had an average gain of 52% in shareholder equity and a median gain of 6.1%. These are solid numbers, which reflect that China’s growing economy is indeed making improvements, and showing up in publically-traded companies’ results. How investors value such gains is another story.

A breakdown by exchange in shareholder equity gains is once again illustrative of the different dynamics among the companies listed in each. At one end of the spectrum, Hong Kong-listed companies grew shareholder equity, on average, by 13.8% and 6.9% on the median. Considering that larger, more mature Chinese companies make up a large segment of this group, this smaller average makes sense. On the other hand, Shanghai listed companies (not Shenzhen, as one may assume) had the biggest average gain, with aggregate shareholder equity up by 77.5% on average. Not surprisingly, the median gain was a much smaller 6.1%, which once again shows how outsized gains by a few companies can skew the average. Figure 10 has the details.

Figure 10. Change in Chinese Companies’ Shareholder Equity Over One Year

Pct. Chg. In Shareholder Equity
Average Median
Hong Kong* 13.8% 6.9%
Shenzhen (Regular) 54.5% 5.8%
Shenzhen (ChiNext) 23.4% 6.7%
Shanghai 77.5% 6.1%
All 52.1% 6.1%

*China-domiciled listings only. † Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

However, Chinese companies’ price-to-cash-flow ratios have been bloated by the soaring stock prices. That suggests cash flows improved only minimally at best during the study year. Figure 11 shows the changes.

Figure 11. Changes in Chinese Companies’ Price/Cash Flow Ratios Over One Year

6/1/2015 Price/Cash Flow 6/1/2014 Price/Cash Flow Pct. Chg. in P/CF
Average Median Average Median Average Median
Hong Kong* 36 10 4 8 804.50% 31.68%
Shenzhen (Regular) 139 37 127 20 9.83% 86.01%
Shenzhen (ChiNext) 83 62 5 41 1536.74% 50.82%
Shanghai 90 21 35 12 158.15% 81.65%

*China-domiciled listings only. † Through June 1, 2015. Source: FactSet, MarketGrader Research coverage universe

To continue the liabilities discussion, debt as a share of total capital is another measure that MarketGrader takes into account. In China, the debt is highest in Shanghai, followed closely by Hong Kong’s China-domiciled companies. Listed companies in Shenzhen have less debt in their capital structures, with ChiNext firms having the lowest of all—as befits newer companies with brief track records. This is logical as Shanghai and Hong Kong contain a higher proportion of SOEs, which generally carry more debt, a hangover from the investment-led stimulus efforts following the global financial crisis. See Figure 12.

Figure 12. Chinese Companies’ Debt to Capital
[visualizer id=”2646″]
*China-domiciled listings only. Source: FactSet, MarketGrader Research coverage universe

At this point, foreign investors are tempted by the growth prospects of companies in China’s stock market, but wary of the huge run-up in stock prices before they arrived. Whether to plunge in now or wait until feverish speculation has abated is a question being debated on equity desks at pension plans, asset managers, mutual funds and the like. As index providers begin adding Chinese stocks, traders and buyers of exchange-traded funds, most of which are index-based, also will face the question.

Even in what is commonly thought to be an overbought market, however, MarketGrader’s growth at a reasonable price methodology – able to be employed systematically across the entire universe of China-domiciled stocks – can identify fundamentally sound, financially healthy companies that may be worthy investment candidates for those focused on long-term capital appreciation instead of the current market frenzy. Next month we’ll look at the top-scoring A-share and China-domiciled companies that have been selected for MarketGrader’s International Indexes.

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