John-Paul Smith, the Deutsche Bank AG strategist who’s been writing about the dangers of buying state-owned Chinese stocks since 2010, says private companies are now a bigger risk to investors as valuations surge.
Smith’s warnings about government intervention in the world’s second-largest economy foreshadowed a shift by money managers away from state-controlled banks, commodity producers and industrial companies, known as SOEs. Investors have instead been piling into privately-owned firms that sell services and consumer goods, propelling an MSCI Inc. gauge of Chinese technology stocks to valuations seven times more expensive than financial companies this month, the biggest gap since 2001.
“It’s more the high valuation in the rest of the market and not the low valuations of the SOEs that I find very risky,” Smith, an emerging-market strategist at Deutsche Bank, said in a phone interview from London on March 18. Investors have “crowded into a relatively small number of stocks.”
Non-state companies from Tencent Holdings Ltd., Asia’s largest Internet firm, to milk-powder maker Biostime International Holdings Ltd. have rallied as investors bet they will be the biggest beneficiaries from the economy’s transition toward services and consumer spending. The gains have helped to stem a 7.8 percent decline in the MSCI China Index this year through yesterday.
Smith advised long-term investors in December 2010 to hold underweight positions in emerging markets including China, citing concern over government intervention in the corporate sector and slowing economic growth.
Since then, the MSCI Emerging Markets Index has tumbled 13 percent and the Hang Seng China Enterprises Index lost 25 percent, compared with a 35 percent rally in the MSCI World Index of developed-nation shares.
Gauges of commodity producers, industrial companies and financials in the MSCI China Index fell between 22 percent and 42 percent, while technology shares rallied 150 percent. The CSI 300 Index of shares in Shanghai and Shenzhen is following the same pattern as the MSCI gauge and the Hang Seng China measure, which mostly exclude mainland-listed stocks.
The combined market value of technology, health-care, telecommunications and consumer companies in the CSI 300 increased to the highest level since at least 2007 versus the broader index in February. Measures of energy and materials companies reached record lows this month, dragging the gauge of 300 companies to its weakest level in five years on March 20.
The MSCI China index slid 0.9 percent at the close. Tencent declined 4.9 percent, the most since Feb. 4, and Biostime dropped 2.1 percent. The Hang Seng China measure and the CSI 300 were little changed. The Bloomberg China-US Equity Index of the most-traded stocks in the U.S. gained 0.6 percent yesterday.
Tencent is the most expensive stock on the MSCI China Index at 17 times net assets, followed by Biostime at 15 times, snack-food producer Want Want China Holdings Ltd. at a multiple of 12 and white-goods maker Haier Electronics Group Co. at 7.3. State-controlled Industrial & Commercial Bank of China Ltd., the nation’s largest lender by assets, and PetroChina Co., the country’s biggest company by market value, both trade at about the same level as their net assets.
Privately-owned companies are more expensive than state enterprises because of superior shareholder returns and exposure to faster growing parts of the economy, according to Standard Chartered Plc.
Services industries accounted for 46.1 percent of the economy last year, with the proportion exceeding that of manufacturing industries for the first time, according to the statistics bureau. The government is seeking to increase the share to 47 percent by 2015, according to its five-year plan. In the U.S., the world’s biggest economy, services comprise about 90 percent of GDP.
“The government is focused on stimulating consumption faster than investment and the state tends to have a greater focus towards investment in the cyclical sectors,” Clive McDonnell, the head of emerging-market equity strategy at Standard Chartered Plc in Singapore, said by phone on March 21. “Investors are more comfortable with the private-sector companies.”
Surging demand for Tencent’s online games, e-commerce platform and WeChat social-networking app in the world’s most-populous nation helped the company boost earnings at a 44 percent annual rate since 2009. Guangzhou-based baby formula maker Biostime lifted profits by an average 123 percent as sales climbed in China, the biggest consumer of whole-milk powder.
China’s cabinet, which approved a plan in May 2012 to boost seven “strategic” industries including technology, said last August the government will increase Internet access and build faster wireless networks to spur growth.
The valuation gap between state-controlled firms and private companies is still too wide given the blurry line between the two sectors, according to Smith.
Tencent tumbled as much as 6.8 percent on March 14 as China’s central bank blocked the company’s plans to offer virtual credit cards. At BYD Co., the electric vehicle-maker that’s backed by billionaire investor Warren Buffett, state rebates comprised more than 180 percent of the company’s total pretax income in 2012, according to CLSA Asia-Pacific Markets.
“A lot of times, the companies are purportedly private,” Smith said. “But when you take a closer look at them, the state influence is very high.”
There are already signs equity investors are cooling toward private companies as valuations rise and the government enacts reforms to loosen its grip on major industries.
The MSCI China Information Technology Index has fallen 6.6 percent from its March 6 record through yesterday as Tencent’s earnings missed analyst estimates, while the CSI 300’s technology gauge slid to its lowest level in seven months last week. The Chinext Index of Chinese small-company shares has dropped 10 percent from its all-time high on Feb. 17.
PetroChina has gained 13 percent through yesterday since reaching an almost five-year low in February as Chairman Zhou Jiping said the company may allow private investment in areas including pipelines and gas exploration. State-controlled China Petroleum & Chemical Corp., the refiner known as Sinopec, has surged 14 percent since announcing its intention to sell part of its oil-retail unit on Feb. 19.
The Communist Party unveiled plans in November for the biggest expansion of economic freedoms since at least the 1990s, including more private investment in state businesses, as it seeks more sustainable sources of economic growth.
Investors should acquire shares in industries such as building materials, steel and finance, while reducing holdings of small to medium-sized companies with high valuations, according to China International Capital Corp.
“Sectors representing the ‘old economy’ have extremely low valuations, whereas ‘new economy’ sectors have stretched valuations and are heavily held by institutional investors,” analysts Hanfeng Wang, Qiusuo Li and Yutong Hou wrote in a note dated yesterday.