Summary
- Many commentators, analysts and investors see China as uninvestable, and pessimism might be peaking right now.
- But when looking at the numbers, we have a country growing with a high pace and trading at a rather low valuation multiple.
- Especially many technology stocks - including Alibaba, Tencent, Baidu and JD.com - are trading at extremely low valuation multiples.
- The bet is risky, but the risk-reward ratio is skewed in our favor.
While U.S. equities (and European equities) are performing quite well in the last few weeks – as it seems likely the market has found a temporary bottom (not the end of this bear market and certainly not a great buying opportunity), the Chinese stock market – exemplified by iShares China Large-CAP ETF ( FXI ) or iShares MSCI China ETF ( MCHI ) – is continuing to decline. And especially on Monday we saw a real bloodbath, with many Chinese stocks declining 20% or more. But not only Chinese companies declined – businesses like Starbucks Corporation ( SBUX ), which depend on China for growth, declined as well.
Uninvestable China
Sentiment about investing in China was already bearish in the last few quarters, but the pessimism might have peaked. When looking at the comments and news articles, we see almost exclusively bearishness as well as doom and gloom (combined with calling investors in Chinese equities morons who deserve what they are getting and the typical “I told you so”). While we still see a reasonable amount of optimism for U.S. equities (which is not only unjustified but the reason we are still far away from the bear market bottom), it seems like we have reached “peak pessimism” for Chinese equities.
Of course, just sentiment being negative is not reason enough to invest in a certain stock, a country, or a sector, but it is at least a bullish sign when people seem to be capitulating and are glad, they sold their position and swear they will never invest in these equities again. When people renounce investing in equities, it is always a good sign for stocks being close to the bottom as everybody who wants to sell has sold at this point.
Long-Term Thinking
I don’t want to praise China as there are countless issues one could mention. However, one very appealing aspect is its ability to think in long-term cycles – a skill many political leaders in Western countries with 4–5-year election cycles seem to miss a bit. And China is clearly thinking in long timeframes and cycles and has clear goals for 2049 (the 100-year anniversary of the People’s Republic of China). Xi naming several CCP allies of his to the party’s politburo standing committee could be a red flag, as it could undermine the necessary critical thinking and lead to several yes-men and stooges. On the other hand, Xi also seems to bow to the vision of China becoming a global superpower and further raising the living standard of the Chinese population. He also seems to act in line with the economic vision Chinese leaders already enunciated decades ago.
And it would also make sense for use to think in long timeframes as well, and especially look at long timeframes. And when looking at the last 5 centuries, we see China always being one of the major economic and political players in the world.
And as Ray Dalio is pointing out (and backing up with data ), China has always been one of the great empires and dominating over countries in the world. Only in the late 19 th century and first half of the 20 th century did the country decline. But now, China is back on its way up (red line) and has been growing with an impressive pace over several decades.
And although growth slowed down, the Chinese economy is still growing with a higher pace than most other countries around the world (especially developed nations). In the last ten years, the Chinese economy grew on average 6.69% while the United States grew only 2.05% and most European countries had to report even lower growth rates. And while China is still reporting one of the highest GDP growth rates in the world, its stock market is trading for one of the lowest valuation multiples. Most European countries as well as Canada are trading for a CAPE ratio between 15 and 20 and the United States still report a CAPE ratio of 25 – China on the other hand has a CAPE ratio of only 12.5.
And China does not have to become the next global superpower and replace the United States. It is enough for China to grow with a solid pace in the coming years and decades (low single-digit growth like most other G7 countries) for many of its companies to be extreme bargains.
Germany, in the late 19 th century, was also on its way to become a global superpower, and if history played out a little differently it might not have been the United States leading the world in the 20 th century. But Germany made several strategic mistakes (two terrible world wars and electing Adolf Hitler were among the big ones). Nevertheless, Germany kept its position among the wealthiest nations in the world, and today it is the leading economic power in Europe and although it could not keep pace with the United States of America, the country performed quite well.
China also doesn’t have to become the next global superpower. It will just be enough when China finds its spot among the 10-15 leading nations in the world (a spot China almost always had in the last five centuries).
And despite all the negativity about the Chinese economy, we should not forget that China is growing with a much higher pace than most other countries around the world (for a reference we can look at the G7 countries, the seven economic superpowers if you will). And clearly, growth is slowing down in China and probably will continue to slow down. However, it seems likely that China will continue to grow at least in the mid-single digits, while most other countries can report only low-single digit growth.
Highly Profitable Companies
In the following sections I will look at four Chinese companies once again – companies I already covered in the past: Alibaba ( BABA ), Tencent ( TCEHY ), JD.com ( JD ) and Baidu ( BIDU ). Over the past two years, the stocks declined between 65% and 80% from previous highs, and it is not uncommon to see terrible companies declining steeply – and the decline being more than justified.
However, we are talking about highly profitable companies (maybe JD.com being the expectation, as it is just on its way to get profitable). And without doubt, growth has slowed down for these businesses in the last few quarters – as it has slowed down for the U.S. counterparts like Amazon ( AMZN ), Meta Platforms ( META ) or Alphabet ( GOOG , GOOGL ). And while many others are obviously seeing a structural issue with the business model of these companies, I am rather seeing a normal recession and economic downturn, which is leading to a bear market for many businesses.
Valuation Of These Stocks
And as it is also typical for many bear markets, stocks are declining rather steeply and are trading for very low valuation multiples – multiples that are often not justified anymore. In my last article about Baidu, I started talking about the price-book-value ratio – a ratio I hardly mentioned in any article during the past – but in this case it is showing how “cheap” these Chinese companies are despite a solid business model and, in most cases, a great balance sheet with a lot of cash. In my last article about Baidu I wrote:
In past decades, the P/B ratio was used quite often by value investors (in the tradition of Benjamin Graham). But similar to many other investors I would argue that the price-book-value ratio is a good ratio for capital-intensive companies (with high amounts of plants, property and equipment on the balance sheet). It is not such a great metric for companies that are not relying on these assets and are offering capital-light services and rely on intangible assets.
We usually argue that the P/Bv ratio is not such a great metric for technology companies – and it is even more note-worthy when technology companies are actually trading for extremely low P/Bv ratios (as most technology stocks are trading for rather high P/Bv ratios). While Baidu is now trading for 0.85 times its book value, Alibaba is trading for 1.16 times book value. There should only be two possible explanations for such a low valuation multiple: either the company will go bankrupt in the foreseeable future, or we are looking at an extreme bargain. JD.com and Tencent are trading for higher price/book value ratios, but still lower than most of the peers.
When looking at the price-free-cash-flow ratio, we see similar low valuation multiples. JD.com is actually trading for 18 times free cash flow and Tencent is trading for 16 times free cash flow. And while these two are not extreme bargains, Baidu trading for 10.3 times free cash flow and Alibaba trading for 7.7 times free cash flow are absurdly low valuation multiples for profitable, growing businesses.
Of course, when China is enforcing capital controls or the Chinese economic should enter a period of long-lasting decline, many stocks would still be overvalued and might have an intrinsic value rather close to zero. But when calculating with – in my opinion – reasonable valuation multiples, all four stocks are trading for a steep discount and the stocks are nowhere close to the real intrinsic value. And we are not depending on double-digit growth rates for any business to be fairly valued.
Risks Remain
And despite my long-term optimism and bullishness about China and Chinese stocks, risks remain, and the level of uncertainty is rather high. Aside from the typical risks that always go hand-in-hand with investing (i.e., markets shifting or management making wrong decisions from a strategical point of view), there are some very specific risks in this case.
Especially capital controls are a huge risk for foreign investors – and like myself, most of you will also be foreign investors from a Chinese perspective. It might seem like this a risk which just arose and should only concern those investing in Chinese equities. But like many other events (i.e., 0% interest rates or a global pandemic), very few events are completely unprecedented. As Ray Dalio is showing, capital controls have always been part of politics – and not only in Chinese or communist countries. During the 20 th century, almost every major economy had periods of strict or rising capital controls.
And in our case, the major risk is a delisting of the ADRs on North American stock exchanges or China forbidding foreign investors to hold Chinese equity.
China turning more and more into an authoritarian state is also a major risk, but from a strictly economic point of view it is not atypical for rising powers to have strong leadership at the beginning of the cycle – and strong leadership can take many forms. And while Communist China and Communist Russia clearly failed, it is not correct to see authoritarian states per se as economically weak.
Great Misunderstanding
There seems to be a great misunderstanding. People are always arguing that Xi Jinping or the CCP might tighten its grip on companies (especially technology companies), and it will be much more difficult for these companies to grow with a high pace. But at this point, we are not talking about high growth rates, we are not even talking about growth. Companies like Baidu or Alibaba are undervalued even if these businesses never grow again and are only able to report similar free cash flow and earnings as in the past few quarters. While we often need mid-to-high single digit growth for many U.S. companies to be fairly valued (and not really knowing if these growth rates will be realistic in the next few years), Chinese equities are often priced for a disaster.
There are also apparent reasons why China is struggling right now. The economic is slowing down right now (as it is happening over in over in every economy around the world) and the COVID-19 lockdowns have a negative effect on the economy (as they did in most other countries around the world). But while investors are able to remain more or less optimistic for the United States, they see structural issues for China although we are probably just looking at a normal recession.
Risk-Reward Ratio
In the end, it is coming down to a risk-reward ratio. The risks right now as immense and the level of uncertainty is extremely high. In my opinion, the path of China becoming the next dominant global power is visible, However, there is not predetermined path and many different outcomes are possible. Additionally, we are also facing risks of China becoming an economic superpower, but foreign investors not being allowed to participate.
While the risks we are facing are rather high, potential rewards is also gigantic. In the most optimistic scenario, we are investing in high-quality businesses with a wide economic moat that will outpace an already above-average GDP growth in China. And we would be able to buy these equities for an extreme discount.
In my opinion, the potential reward is worth to take the risk. And I know I have been wrong about Chinese companies in the last few quarters. I was already bullish while the stocks continued to decline. And if you asked me a year ago if I could imagine these four stocks trading at a price they are trading for right now, the answer would have been “No!” But I still believe my bullish thesis is correct – even if it appears like we can count “Chinese bulls” on one hand now.
It is also funny how many American investors are pointing towards Chinese stocks, not realizing that many stocks in the United States are in a far worse condition right now. Growth in the United States will most likely be lower in the years to come. Nevertheless, many of the stocks in the United States are trading for huge premiums, and in the coming quarters we should see a repetition of the current Chinese stock market drama in the United States.
For further details see:
Who Is Afraid Of Xi Jinping?