Investors wanting to invest in China have to work hard to understand what they are buying.
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Here are some of the questions that we try to answer in this article:
- Aside from the financials, do other sectors of the market offer good value relative to growth?
- Is the slowdown in the economy reflected in earnings growth?
- Are Chinese companies highly leveraged?
- How can you get exposure to the services sector, which is growing faster than the manufacturing sector?
In order to answer these questions we have drilled down into the various sectors of the MSCI China Index and amalgamated the financial results of the largest companies to get a representation of the sub-sectors. The results in the tables below are only for the specific companies named and not for the sectors as a whole. Sector performances are averages of the selected companies for 2015 as of end August 2015. We have not analysed the energy or materials sectors as earnings growth there would be more dependent on commodity prices that are determined based on global supply and demand.
Financials make up the largest share of the MSCI China Index at 40.3%. Of that, the majority relates to banks with the remainder comprising insurance, property and stockbrokers. For the purpose of our analysis we have taken the four largest banks by weight as well as the two largest insurance companies. This is the only sector that should be regarded as “cheap” with a trailing PER of 7.9x. Despite this and the strong growth in premiums of 19% and bank pre-provision profits of 12% in H1 2015 year-on-year (y-o-y), the share prices have declined by -9.6% in line with the decline of the MSCI China Index. That’s because the market is worried about the rapid growth of loans in the People’s Republic of China (PRC) financial system and the potential for substantial bad debt charges leading to impairment of bank balance sheets. The fact that bad debt charges and non-performing loan ratios have been increasing can either be taken as a wise move to bolster bank balance sheets or a sign that bad debt problems will escalate from here.
The Information Technology sector is dominated by Tencent which makes up 79.2% of the sector. Top line growth has decelerated partly because the e-commerce business has been transferred to JD.com. Earnings growth remains respectable and would be 30% on a non-GAAP basis. The company maintains a net cash balance. Although pricey at 38x trailing earnings, the stock has done well, rising 17.5% in 2015 as of end August. This is because it’s considered to be the best way to invest in the increasing use of the internet for entertainment, social media and shopping.
The Telecommunication Services sector is dominated by China Mobile which makes up 81% of the sector. Revenue and earnings growth, although unexciting, are on an improving trend helped by the launch of its 4G network. Valuations are low especially on an EV basis which recognises the company’s large cash balances. Because of these positive factors the stock price has outperformed the broader index for 2015 through to end August.
The Industrials sector covers a wide range of companies comprising construction, the environmental sector, railways, shipping, airlines and conglomerates. We have selected the top seven companies, with the exception of CITIC and CRRC which have undertaken restructurings making analysis harder. Overall, the sector is attractive, delivering growth of 18% in H1 2015 and trading on a trailing PER of 14x. This is because the sector has a heavy weight in areas where the PRC government wants to commit more resources, such as railways and clean energy, leading to faster than average growth. This has led the stocks to outperform with an average decline of -1.1% in 2015. What may be holding the sector back is uncertainty over whether favourable policies will continue and the relatively high leverage – the debt to equity ratio is 41%.
The Utilities sector covers power producers that use traditional coal, wind and nuclear for their energy source as well as companies in the water supply/treatment sectors. We have selected the six largest (with the exception of CGN as historical data is limited) covering 61% of the sector. Profits have grown at an impressive rate of 24% in H1 2015 and the trailing PER is 13.6x. Behind these numbers there is a large divergence with companies in the wind and water sectors reporting rapid growth and trading on high valuations. Whereas, the traditional coal-fired electricity producers are reporting reasonable growth (due to lower coal prices), but are trading on lower valuations due to a lack of top line growth. This is the sector with the highest debt level of 95% of equity. Share prices have outperformed with a decline of 1.2% for 2015 through to end August.
The Consumer Discretionary sector has a heavy weight in motor vehicle manufacturers which make up 50% of the sector by weight. This sector is performing poorly with motor vehicle sales in China declining y-o-y in both June and July with the fall being particularly severe for the foreign brands. However, other areas of the sector are doing well, such as sports goods manufacturer Anta and knitwear manufacturer Shenzhou (supplier to Uniqlo, Nike and Adidas). In aggregate, the sector is financially strong with net cash and trades at a reasonable valuation of 12.1x trailing PER. Earnings are weak but this should be temporary as car sales will recover over time.
Overall, the sector is in good health enjoying net cash and high returns on invested capital. Top line growth has been disappointing in H1 2015 at zero. This is due to several factors: lower prices following a fall in input costs, more competition from foreign or smaller local companies and slower industry growth due to the overall macro economy. The bright spot is that, in aggregate, margins have improved leading to a 9% earnings increase in H1 2015. Despite this, investors have been disappointed in the lack of top line growth and the stocks covered have recorded an average price decline of 19% in 2015 through to the end of August. The stocks are reasonable value at 19x trailing PER. In order to maintain earnings growth amidst fiercer competition they need to continue to differentiate themselves by focusing on higher margin products.
The Health Care sector has performed well in 2015. Industry statistics show that revenue growth in the pharmaceutical manufacturing industry was 8.8% and in the pharmaceutical distribution industry was 12.4% in the first half of this year compared to a year ago. The major companies in the sector were able to grow revenues faster than the industry average of 15% and also improve margins so that net profit increased by 29%. The sector has little net debt and returns on capital remain high. The share prices have done well and the stocks covered have recorded an average price gain of 15% in 2015 through to the end of August. This is the second most expensive sector after information technology, trading on a trailing PER of 22x.
- China as a whole is good value – only the Financials sector and car manufacturers (within the Consumer Discretionary sector) offer single-digit PERs
- The Health Care, Industrials and Utilities sectors have delivered strong H1 2015 growth that is above their trailing PER
- Telecommunications is a sector that is not growing quickly but is on an improving trend
- Utilities is the only sector where leverage is high
- Exposure to the Services sector – where growth is faster than manufacturing – is readily available.