Saturday, August 30, 2008

U.S. versus China

Everywhere I turn I seem to bump into another article warning investors away from China and cautioning investors from putting money into the Chinese stock market. It never fails to amuse me that this advice always seems to be given AFTER a market has fallen over 50%. Let's take a look at the Chinese stock market and compare it to the S&P500.

The S&P 500 is down about 18.5% from its peak last fall. On a trailing basis, its P/E is 18.4x on an operating basis and 24.7x on a reported basis. Neither are attractive entry levels historically. U.S. GDP growth, corporate earnings growth, and corporate profit margins had all been above trend for many years. It's likely that all three will spend some time below trend over the next few years. Despite a recent rebound in exports, the U.S. still has a large trade deficit, and our national debt, deficit, and unfunded liability position portend further long-term deterioration in the value of the dollar.

China's Shanghai Index is down 60% from its bubbly peak of last fall. On a trailing basis, its P/E is about 16x, which is the lowest it has been in over 10 years. As for growth, the Chinese outlook over the long-term is far more robust than that of the U.S. There will be hiccups and problems along the way, but demographics, rising incomes, and China's cost advantage (even with higher oil/transport prices) are likely to fuel strong growth in China for some time (think decades). Yes, there are plenty of problems in China (as there are everywhere), but what the Chinese have accomplished in just the last 10 years is nothing short of astounding. Furthermore, they have a large trade surplus and a steadily (managed) appreciating currency. In many ways, the Chinese are much better capitalists than we are.

If you have a longer-term investment horizon and were going to buy one of these markets and then ignore it for the next 10 years, which would you buy? Hopefully, that was read as a rhetorical question. Chinese stocks went parabolic and were in a bubble, but they've come down hard to a pretty attractive level.

When will the Chinese market bottom and at what level? No one knows. It will be determined by psychology and valuation. It isn't at all unusual for attractive valuations to become absurdly cheap at the bottom. I wouldn't be at all shocked if the Chinese market traded with a 10 P/E at its bottom. Even with strong earnings growth, that could mean a further 30% drop in the market. For this reason, I've been gradually building a Chinese position since the spring rather than trying to pick a spot. The ultimate size of this position will depend on just how silly things get on the downside relative to other opportunities.

As a reminder, this optimism about Chinese stocks is long-term optimism. Substantial downside over the next quarter or year would hardly be surprising. Turning to that long-term view, the realistic return possibilities built into today's market level are fairly attractive. The table below is very simplistic, but it illustrates the point. It provides the compounded future 10-year returns on the Shanghai index for each set of earnings growth rates (x-axis) and ending P/E values.

Trailing P/E in 10 years

10.00 12.50 15.00 17.50 20.00
2.50% -2.22% -0.02% 1.82% 3.41% 4.80%
5.00% 0.16% 2.42% 4.31% 5.93% 7.35%
7.50% 2.55% 4.86% 6.79% 8.45% 9.91%
10.00% 4.93% 7.30% 9.27% 10.97% 12.46%
12.50% 7.32% 9.74% 11.76% 13.49% 15.02%
15.00% 9.70% 12.18% 14.24% 16.02% 17.58%
17.50% 12.09% 14.62% 16.73% 18.54% 20.13%
20.00% 14.47% 17.06% 19.21% 21.06% 22.69%

It would hardly be a stretch to imagine trailing P/Es at or above 20 in a more normal environment for a high-growth country. It also doesn't seem unreasonable to imagine earnings growth north of 7.5% per year given consensus expectations for GDP growth and what are likely to be rising margins as China expands more into services and higher value-added manufacturing over time. With these assumptions, the Chinese market would provide an average return in the low double-digit to mid-teen range.

If we happen to see another bubble within the next 10 years and the Chinese market were to trade at the trailing multiple it reached this past fall, the average annual compounded return would move closer to the 20% range.
Of course, there are risks. There's always the prospect for political turmoil. Higher wages and transportation costs could severely crimp export growth. No one really has a great handle on the quality of bank assets. A severe global slowdown would also impact growth. If growth disappoints, then earnings multiples are likely to be lower.

There will be hiccups along the way. Despite the inevitable growing pains, the future of China appears to be very bright.
Their stock market is a "Rip Van Winkle Buy."

Disclosure: The Rubbernecker is long table tennis, Mah Jong, the number 9, and General Tso tofu.