Will China continue to drive the rally in GEM Equities?

WILL CHINA CONTINUE TO DRIVE THE RALLY IN GEM EQUITIES?

MAY 2015EMAD MOSTAQUE & JP SMITH, ECSTRAT

[email protected] | [email protected]

2

GEM 2015; ALL ABOUT CHINA, VALUATIONS AND GOVERNANCE

1. The growth slowdown in China will continue to dominate EM equity and global financial markets. We believe that whilst Beijing may be

successful in achieving a short term stabilisation, the underlying governance issues in China are now almost impossible to resolve.

Whilst EM and other cyclical assets might continue to perform relatively well in the short term, we believe that the big picture is for further

dollar strength and for outperformance of DM, in particular US assets.

2. Within North Asia, the strong Chinese equity market is causing overseas money to flow into Taiwan and into Korea, although the

benefits have not been shared by the majority of companies which compete with Chinese producers. We have long regarded Taiwan as

a good defensive market, but are becoming concerned about the extent of foreign inflows. We remain sceptical about the prospects for a

real shift in governance in Korea in a more liberal direction, despite recent legislation aimed at the chaebol.

3. In South East Asia, the more obviously expensive markets such as Indonesia and the Philippines are starting to suffer from the

rehabilitation of China, Brazil and Russia, which are optically much cheaper. Much the same could be said about India where the

difficulties facing the BJP governments efforts to turn around the Indian economy are becoming increasingly clear. Malaysia is beset by

governance concerns at the political and stock level, but given the state’s close control of the market, should be relatively low beta.

4. Within LATAM, Chile has been de-rated due to the falling copper price and political/governance concerns while Mexico is now fairly

valued relative to its own history and should be relatively low beta. Brazil is cheap on asset based valuation ratios, but economic

problems are deeply embedded in the absence of rising commodity prices.

5. CEMEA is uninspiring to say the least. Russia remains cheap but the corporate sector is vulnerable to state action to address falling

living standards, whilst the economic outlook appears very poor on a longer term perspective. South Africa is very expensive (rated at

the same level as the US!) due to a combination of good governance at the stock level and captive demand for shares. Poland and

Turkey are both cheap beneficiaries of low energy prices but beset by concerns about the potential impact of state intervention at the

company level.

6. Meanwhile we believe that the outlook for developed equity and bond markets is also highly dependent on how the situation in China

plays out. If the economy shows signs of stabilisation, government bond yields are likely to move higher as core inflation gently

strengthens, while the dollar will remain stable or fall back a little. If or when the Chinese equity market breaks down, we can expect to

se a much stronger dollar, lower USTs and a major breakdown in commodities and commodity dependent equity markets.

3

MSCI INDEX PERFORMANCE VERSUS S&P 500

IS THE CHINA BULL MARKET A LEAD INDICATOR FOR GEM?

Source: Ecstrat, Bloomberg

4

CHINA; REAL LEVEL OF ECONOMIC ACTIVITY BELOW OFFICIAL DATA

CHINA NEW STARTED FLOOR SPACE YOY %

CHINA FREIGHT TRAFFIC VOLUMES YOY %

CHINA TOTAL ELECTRICITY CONSUMPTION YOY %

CHINA VALUE ADDED OF INDUSTRY YOY%

Source: Ecstrat, Bloomberg, NBS, NEA

5

CHINA GROWTH SLOWDOWN DRIVEN BY MASSIVE MISALLOCATION OF CAPITAL.

• Authoritarian rather than guided governance regime, designed for the mobilisation phase of

economic development, namely massive infrastructure build-out and urbanisation.

• Local government has been able to support ‘their’ enterprises through a network of direct and

covert subsidies resulting in growing overcapacity across a wide range of industries.

• Central government has also used big strategic holdings to facilitate national development, social

and geopolitical objectives.

• Very blurred boundaries between private and state sectors and limited transparency, mean

conventional distinctions between private and state control are not so applicable.

• Soft budget constraint prevalent; despite 2007 bankruptcy law, the number of bankruptcies

handled by Chinese courts fell to 1,920 in 2013 from over 10,000 in 2006 (Reuters)

The result has been a steady deterioration in Total Factor Productivity at a macro level and a build up

of debt at both local government and a significant part of the corporate sector.

6

SOCIAL FINANCING FLOWS (% GDP)

Source: OECD, CEIC and China Trust Association

CHINESE GROWTH BASED ON INCREASE IN CORPORATE DEBT

CHINA’S DEBT REACHED 282% OF GDP IN 2014

0

5

10

15

20

25

30

35

40

Bank credits Entrusted loans

Trust loans Corporate bonds

Source: McKinsey Global Institute

7

CONTRIBUTIONS TO GROWTH

Source: OECD, Asian Productivity Organisation’s Productivity Database

POOR GOVERNANCE LEADS TO LOWER PRODUCTIVITY

TOTAL FACTOR PRODUCTIVITY (%)

0

2

4

6

8

10

12

14

2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

Labour Capital Total factor productivity

0

1

2

3

4

5

6

7

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012

8

COMPARISON OF CHINA WITH OTHER GOVERNANCE REGIMES

NIEs; Joe Studwell, ‘in Japan, Korea and Taiwan,

the state did not so much pick winners as weed

out losers’. Singapore has been very successful

with a state-led guided governance regime, but

within the context of a corporate sector that is

subject to a hard budget constraint and where

listed holdings are managed at arms length via

Temasek. Chinese enterprises benefit from

extensive cost factor subsidies, especially at the

local level, which are more reminiscent of Russia

pre-1998 financial crisis, though the macro

situation is totally different.

Import substitution drive is very similar to ISI

policies pursued by S European and Latin

American countries beginning in the 1950s,

though the theoretical base was laid in the 1930s.

Brazil and the former Soviet Union both had many

years of extremely rapid growth during their

respective mobilisation phases, only to fail to

surmount the so-called middle income transition.

INVESTMENT RATIOS AND GDP GROWTH

Incremental Capital Output ratio (ICOR)

2

3

4

5

6

1973 1978 1983 1988 1993 1998 2003 2008 2013


Source: Nomura

9

BLURRED BOUNDARIES CONFOUND PRIVATE SECTOR NARRATIVE

• Lenovo (probably a mixed ownership firm given relationship with Legend/China Oceanwide)

• Haier (opaque ownership structure – supposedly under control of collective/employee ownership)

• ZTE (control unclear – looks like a genuine hybrid)

• Huawei (subsidies, CDB lending, alleged links with security service, opaque ownership structure)

• Sany Heavy (recipient of generous local government largesse)

• Geely (big recipient of subsidies)

• China Mengniu Dairy (COFCO now holds 28% post-milk scandals)

• Rongsheng – big recipient of state state support, now diversifying into alternative energy

• Suntech/LDK Solar (subsidies, SOE support, most likely at behest of local government)

• Sinovel (faced with delisting after two years of losses; has effectively been rescued)

China uses the term gaizhi or restructuring as opposed to privatisation. Even where enterprises were

taken out of state control, many retain strong links with local government.

Roughly one third of companies are definitely state controlled, one third private or foreign controlled

and the rest somewhere in between. It is not at all clear that private industry is expanding at the

expense of the state, in fact the opposite appears to be the case in the current stimulus.

The boundaries between the state and private sector are very blurred as shown by the ongoing anti-

corruption drive and the recent Bloomberg/NYT revelations concerning links between leaders families

and ‘private’ companies. Most private companies are in receipt of subsidies or other aid.

10

CORPORATE SECTOR BEST GAUGE OF PRESSURE POINTS (1)

HANERGY

CHINA NATIONAL BUILDING MATERIALS

NINE DRAGONS PAPER HOLDING

HEBEI IRON & STEEL


11

CORPORATE SECTOR BEST GAUGE OF PRESSURE POINTS (2)

CHINA COSCO HOLDINGS

ZOOMLION

YANZHOU COAL MINING

SANY HEAVY


12

WHAT IS BEIJING DOING TO AVERT A NEAR CRISIS IN LOCAL GOVERNMENT AND

CORPORATE FINANCES?

The rhetoric stresses SOE and fiscal reform – the reality appears very different, namely an effort to

shore up the existing growth model within China and also to export it abroad both directly via the

overcapacity industries and also longer term through the ‘One Belt, One Road’ scheme.

SOE reform?

• The combining of SOEs in some of the key industries to form even larger SOEs such as railways,

possibly oil and power – supposedly from 112 to 40 strategic companies.

• Mixed ownership reform purports to give management more autonomy but has involved minority

stakes in SOEs businesses, so Beijing or local government retains control. The real objective

appears to be to attract additional external funding into SOEs (Sinopec’s petrochemical assets,

CITIC, CNBM, Sinopharm, COFCO Land).

• Purported consolidation in many industries which should benefit large listed companies but

precedents are not always encouraging (CNBM, Nine Dragons, Hebei Iron & Steel).

• Transformation of SASAC(s) into Temasek style arms-length relationship with companies appears

distant, given widespread bail-outs and prioritisation of political over commercial objectives.

• Will there be ‘stealth’ restructuring via attrition, albeit without big rise in formal bankruptcies?

The central thrust of policy is to attract more dis-intermediated finance into enterprises via the

corporate sector. There have been repeated bailouts of individual companies and of whole industries –

those industries which are exhibiting some signs of improvement are mainly beneficiaries of additional

state largesse (alternative energy, shipbuilding).

13

BIG OIL SOE SHARE PRICES LOSING TOUCH WITH REALITY

Source: Bloomberg

SOE REFORM BENEFICIARIES CONTRASTING EARNINGS PROFILE

RAILWAY GIANTS BENEFIT FROM INFRASTRUCTURE SPEND

40%

60%

80%

100%

120%

140%

160%

180%

200%

01/14 04/14 07/14 10/14 01/15 04/15

Sinopec Sinopec EPS BF12M

Petrochina Petrochina EPS BF12M

0%

20%

40%

60%

80%

100%

120%

140%

160%

0%

100%

200%

300%

400%

500%

600%

700%

800%

900%

01/14 04/14 07/14 10/14 01/15 04/15

CNR CSR CNR EPS BF12M CSR EPS BF12M

14

NO STRONG EVIDENCE FOR REBALANCING

RETAIL SALES YOY %

WESTPAC MNI CHINA CONSUMER SENTIMENT

CHINA CONSUMPTION SHARE OF GDP

Source: Ecstrat, Bloomberg Source: Quartz, World Bank

15

HOW LONG WILL THE INTENSIVE PHASE OF URBAN GROWTH CONTINUE?


Whilst it may appear that the most intensive phase of Chinese urbanisation is not over,

there is considerable evidence that official Chinese statistics understate the amount of

urbanisation that has already taken place. ‘Urban Trends and Policy in China’ published by

OECD in 2009 states that ‘there are likely many villages and undesignated towns in in

China that would in most OECD countries be designated as towns and far more towns …

that would administratively be defined as cities’.

16

MACRO SITUATION IS SLOWLY DETERIORATING

CHINA CENTRAL GOVERNMENT REVENUE YOY %

BLOOMBERG CHINA MONETARY CONDITIONS INDEX

CURRENCY VERSUS KEY TRADE PARTNERS

RESERVE RATIO ADJUSTMENT STARTING


17

CAPITAL FLIGHT RISKS RISE IF CONFIDENCE IS ERODED

Top reasons better education and employment

Opportunities for children (78%), economic

Security and desirable climate (73%)

Better health care and social services (18%)

18

A SHARE RALLY HAS STRONG SPECULATIVE ELEMENT

NEW A SHARE ACCOUNT OPENINGS AT RECORD

RATIO OF SSE 180 TO SMALL CAP 380

BEIJING BAOFENG LIMIT UP DAILY > 2000% FROM IPO

RALLY ENTIRELY DUE TO RERATING


19

INDUSTRIAL/MATERIAL COMPANIES UNDER PRESSURE & EXPENSIVE

Date Capex/S AP/S AR/S D/E Liabilties/E Inventory/S Net Margin PB PE FCF/S ROE

07/05/2015 7.0% 14.0% 13.2% 82.5% 160.3% 17% 1.2% 3.2 142.5 -0.9% 2.3%

31/12/2014 7.1% 12.5% 12.0% 81.4% 158.0% 17% 1.7% 2.1 61.9 -1.9% 3.4%

31/12/2013 8.4% 11.5% 12.4% 82.1% 152.4% 17% 1.4% 1.6 54.7 -5.0% 2.9%

31/12/2012 8.8% 10.8% 12.1% 75.7% 149.0% 18% 1.4% 1.8 60.6 -6.1% 3.0%

31/12/2011 8.0% 10.5% 10.9% 71.4% 147.2% 18% 4.0% 1.9 21.8 -4.9% 8.8%

31/12/2010 8.6% 10.8% 10.5% 72.2% 147.2% 20% 3.1% 3.3 51.9 -5.7% 6.3%

31/12/2009 13.0% 12.6% 10.8% 71.7% 146.9% 20% -1.5% 3.2 (127.5) -3.3% -2.5%

Materials

Date Capex/S AP/S AR/S D/E Liabilties/E Inventory/S Net Margin PB PE FCF/S ROE

07/05/2015 5.5% 24.0% 25.3% 40.2% 179.0% 34% 4.3% 3.8 49.9 -2.8% 7.7%

31/12/2014 5.1% 23.4% 25.8% 43.9% 180.5% 36% 4.4% 2.5 32.4 -3.8% 7.7%

31/12/2013 5.2% 22.5% 24.9% 38.5% 175.9% 34% 4.0% 1.9 26.1 -3.2% 7.3%

31/12/2012 6.2% 19.7% 22.2% 35.4% 176.5% 30% 4.4% 1.8 20.5 -5.7% 8.8%

31/12/2011 6.3% 18.8% 20.6% 29.9% 174.5% 29% 5.6% 2.0 18.3 -7.1% 11.1%

31/12/2010 6.8% 19.9% 21.0% 21.5% 160.6% 28% 5.3% 3.5 38.6 -4.3% 9.1%

31/12/2009 8.4% 18.3% 18.1% 43.5% 186.1% 27% 4.4% 3.8 43.0 -2.0% 8.8%

Industrials

Source: Ecstrat, Bloomberg. Data aggregated on all China-listed stocks

20

INDUSTRIALS AND MATERIALS HAVE LED THE WAY OVER LAST 3M

Source: MSCI, Bloomberg

21

CHINA MOST PRONE TO DILUTION (PRICE TO MARKET CAP FOR KEY MARKETS)

Source: Bloomberg, Ecstrat, MSCI

22

LOCAL CHINA MARKET IS A HUGE VALUATION OUTLIER WITHIN GEM

Source: Bloomberg, Ecstrat, MSCI

CSI 300

SSE 380

Brazil

Russia

India

ChinaTaiwan

Korea

Indonesia

SSE 180

Turkey

South Africa

Thailand

Malaysia

Philippines

Mexico

Poland

Chile

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

0% 5% 10% 15% 20% 25%

23

MSCI CHINA IS CHEAP FROM TOP DOWN PERSPECTIVE

Source: MSCI, Bloomberg

24

BUT LOW VALUATION ARGUMENT DEPENDS ON FINANCIAL SECTOR

DescriptionP/E Ratio

FY 1Dividend

Yield P/B Ratio

FY 1EV/EBITD

A FY 1

China

MSCI China Index 12.61 2.27 1.62 10.22

MSCI China Consumer Discretionary Index 12.43 1.88 2.16 14.79

MSCI China Consumer Staples Index 23.96 1.78 2.70 12.98

MSCI China Energy Sector Index 19.65 3.69 1.12 8.49

MSCI China Financials Index 8.55 2.96 1.28

MSCI China Health Care Index 22.48 0.90 3.12 14.66

MSCI China Industrials Index 15.81 1.27 1.71 12.87

MSCI China Information Technology Index 31.38 0.37 6.32 20.49

MSCI China Materials Sector Index 14.45 1.63 1.36 11.80

MSCI China Telecom Services Index 16.84 2.48 1.72 5.28

MSCI China Utilities Index 14.29 1.76 2.07 9.71

Taiwan

FTSE TWSE Taiwan 50 Index 13.42 2.64 1.82 8.71

Hong Kong

Hang Seng Index 13.53 3.09 1.46 10.51

Hang Seng China Enterprises Index 10.13 2.69 1.34

Source: Ecstrat, Bloomberg, MSCI

25

POSSIBLE SCENARIOS FOR THE CHINESE MARKET

1. ‘Business as usual’ - the stimulus combined with lower commodity prices puts a floor under the

economy, which begins to show signs of stabilisation. If the pattern of the past five years persists,

sell China on good economic news and buy on bad news, so at the very least the market levels

out and may retrace some of the gains as monetary and fiscal policy becomes more

contractionary.

2. ‘Boom and bust’ - Beijing looses control over the equity market which behaves in a similar way

to 2007-08 and eventually topples over a little like NASDAQ in 2000, simply because of the weight

of supply of stock and in China’s case the increasingly obvious dichotomy between the

fundamentals and the equity market.

3. ‘Stronger for longer or Japan redux’ - the boom becomes a prolonged bubble like Japan in the

mid/late 1980’s against the backdrop of a gradually improving economy, as Chinese retail

participation continues to grow exponentially and overseas investors are sucked into the market in

greater numbers, especially if Chinese A-shares are admitted into the main global investible

indices. If this happens and company-level governance continues to be very poor, the eventual

result will be wealth destruction on a massive scale, but the denouement could be 2-3 years away.

26

DEBT BUILD SINCE THE GFC IN TERMS OF DEBT TO EV


NO DEFINITIVE SIGNS OF A TURNAROUND IN EM SOE GOVERNANCE

At the corporate level the debt build has been clear.

This has led equity to behave in an almost option like way, which

increases the risks to minority shareholders.

The 100% rise in Petrobras’ share price represented a mere c20%

increase in its EV.

In China, the capex cuts in 2014 and cash retention seem to have

improved ratios but they remain elevated.

WHAT ARE WE SEEING AT THE MICRO LEVEL?

Petrobras: Corruption is much more difficult now! New Chief

Governance, Risk and Compliance officer. The fall in the oil

price has removed product subsidies, though policy remains

unclear. The company has been forced to lower capex as local

suppliers have been bankrupted by the ‘Car Wash’ scandal.

Management have changed. Yet despite market attempts to

impose discipline the company still increases total debt. $3.5bn

from China Development Bank for example. Disposals will help

the position though.

Vale: making noises about decreasing production and may have

held back some iron ore from the market but it is pushing ahead

with the S11D project and seems to be keen to push out smaller

producers. Rio is following the same course so this is more of

an operational/strategic than a governance issue..

Rosneft: ‘announced a 10% cut in spending’ (at least that is

what Sechin told Putin). But the company has filed for

shareholders to approve the ability to raise $200bn in debt from

domestic banks. A change in accounting for forex movements

has seriously flattered results for 1Q15.

Hebei Iron and Steel: looking to expand overseas, it is

building a 5m tonne plant in South Africa for example. A run up

in accounts payable has generated an improvement in cash

flows, at the expense of suppliers. A change in depreciation

accounting standard flattered 2014 results.

Conclusion: material and energy based companies are mainly

still in ‘react’ mode, whilst there is little real evidence of any real

transformation in the SOE mindset, other than the need to bring

debt down to something approaching a manageable level. The

risks for minority shareholders in some SOEs could become

critical if slowing China drives further declines in commodities.

27

PLUNGING CAPEX ACROSS BRICS (EX-INDIA) BODES ILL FOR GROWTH

28Source: IMF

EM SIGNIFICANT CONTRIBUTOR TO GLOBAL FORECAST ERRORS

[email protected] | [email protected]

29

WORLD AND ADVANCED VERSUS EMERGING MARKET GDP GROWTH

IMF REMAINS (OVERLY) OPTIMISTIC ON EM VS DM ECONOMIC GROWTH

30

US COMPANIES SUPERIOR ABILITY TO GENERATE FREE CASH FLOW

Source: MSCI, Bloomberg, Eclectic

EM C/S 10 C/S Now Change FCF 10 FCF Now Change

Energy 14.8% 15.8% 7% -0.2% 2.7% 1320%

Industrials 3.9% 5.0% -23% -2.6% -0.4% 83%

Consumer Staples 4.6% 5.2% 12% 5.3% 3.2% -39%

Consumer Disc 5.0% 5.5% 9% 8.0% 2.0% -75%

Materials 13.1% 9.8% -25% 4.8% 2.5% -48%

Healthcare 5.8% 4.6% -20% 16.3% 5.1% -69%

IT 5.1% 7.5% 47% 6.4% 5.8% -10%

Telecom 18.9% 18.5% -2% 12.5% 8.5% -32%

Utilities 19.3% 19.1% -1% -1.3% 1.8% 237%

US C/S 10 C/S Now Change FCF 10 FCF Now Change

Energy 12.5% 16.8% 35% 1.5% -0.6% -140%

Industrials 4.2% 5.9% 41% 8.9% 7.5% -16%

Consumer Staples 3.3% 2.8% -14% 6.5% 6.6% 1%

Consumer Disc 4.5% 4.8% 6% 3.3% 6.4% 94%

Materials 6.0% 8.3% 39% 6.1% 5.8% -4%

Healthcare 1.9% 1.9% 1% 11.0% 9.2% -17%

IT 3.8% 6.0% 59% 16.8% 20.3% 21%

Telecom 13.2% 14.0% 6% 13.8% 10.3% -26%

Utilities 20.9% 24.4% 17% 1.8% -1.0% -154%

There is little evidence in this table to support the contention that listed US companies across all

industries are systematically low investors relative to their EM peers. What does stand out is the

ability of most US companies to extract more cash from their businesses for the given level of

investment, across all industry groups with the exception of energy and utilities. Moreover listed

companies in most US sectors have been increasing their capex relative to sales, whereas the

picture in EM is much more mixed.

31

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Will China continue to drive the rally in GEM Equities?

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Transcript of Will China continue to drive the rally in GEM Equities?