Does China still make Dollars and Sense?

The recent inflection point in Chinese equities provides us with an opportunity to re-evaluate the investment thesis on China.  Entering June, China was the #1 overall ranked country in the Accuvest Global Core Equity universe.  China has been ranked #1 since January 2015 and has been a top 2 overall country since September 2014.  Over the last 6 months, the MSCI China Index has returned 10x the MSCI USA Index (in local currency terms), and this level of divergence certainly warrants a review of the relative attractiveness of Chinese equities.

Our data suggests that the powerful medium term momentum seen in China is supported by a unique blend of strong growth, attractive valuations, and below average risk.  While momentum is very strong (ranked #1 overall), there is plenty of data supporting the case for continued China out-performance.  For one, the MSCI China Forward PE, currently at 12.6x, sits at its 10-year average, while the MSCI United States Forward PE, currently at 17.4, is two standard deviations above its 10-year average.

Relative to the MSCI USA Index, the MSCI China Index has:

  • 6x the US Long Term Sales per Share growth
  • 6x the US earnings yield
  • About half the P/B ratio (1.7x vs. 2.9x)
  • A Growth to P/E Ratio (PEG Ratio) of 1 versus 0.5 in the US
  • 10x the 6 month returns of the MSCI US Index in LCL terms
  • 5x the 12-1 month returns of the MSCI US Index in LCL terms
  • A more competitive currency

The MSCI China Index is very attractive relative to the US and the 32 country Accuvest Global Core Equity universe.  Entering June 2015, China was ranked:

  • 4th in overall fundamentals (vs. 7th for the US)
  • 4th in valuation (vs. 28th for the US)
  • 1st in momentum (vs. 18th for the US)
  • 13th is risk (vs. 1st for the US)

Overall risk is higher in China, but not above average.  Beyond the quantitative risk data, we see concrete signs of China’s willingness and ability to defend growth and protect against a significant credit event.  Recent reforms have allowed local municipalities to roll over debt to lower interest rates and longer maturities. Last week we received data showing that China’s home prices fell in fewer cities for a third straight month as buyers’ confidence returned after the government removed some property curbs and interest rates fell.  China eased mortgage policies and down-payment requirements for some home buyers at the end of March, adding to easing measures since September to aid an industry that has been weighing on economic growth. We anticipate that the government will act to keep the equity bull market intact. New broker accounts, at 30 million (in April and May), exceeded the records set in the last bull market.  Going forward, authorities will likely reduce the pace of initial public offerings, and clarify margin trading rules.  We would consider market sell offs on prudent reforms to margin requirements a buying opportunity.  Additional upside performance catalysts include progress on macro-themes such as e-commerce, the new Silk Road of trade routes, clean energy/pollution control, further tail risk reduction as LGFVs debts are restructured, capital account liberalization, and M&A.

Our research suggests that 1 month momentum is not an optimal investment indicator.  Medium-term momentum is much more statistically significant, and blending momentum factors with strong fundamentals, attractive valuations, and a low risk profile yields better long-term risk adjusted returns.  Accordingly, we will remain constructive on the MSCI China Index until momentum, fundamentals, valuation and risk suggest otherwise.

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