Looking at the moderate drop in U.S.-traded Chinese stocks, you could be forgiven for thinking that investors haven't quite grasped the reality of the country's slowdown.
The 65-member Bloomberg China-US Equity index, which is strongly weighted toward Internet companies, has fallen 10 percent in the six months through May 20. That compares with a 26 percent slump in the ChiNext index of emerging and technology companies traded in Shenzhen.
The decline has pushed Chinese stocks in the U.S. to an average of 28 times this year's estimated earnings, from almost 42 times at the peak of the country's stock boom in early June. By comparison, the ChiNext's valuation topped out at more than 80 times and has since slumped by more than half to 33 times.
In theory, high P/E ratios reflect the prospect of superior growth. Investors bet that revenue and earnings at these smaller companies will increase at a rate that will eventually justify their valuations.
That assumption is being tested. For one thing, the names that dominate U.S. listings are no longer small: Alibaba, the biggest, has a market cap of $194 billion. The largest company on the ChiNext, Guangdong Wens, is valued at $24 billion.
Second, growth has slumped. Owing both to industry maturity and China's economic headwinds, average quarterly revenue gains over the past three years have almost halved, to 26 percent in the most recent period from 49 percent.
That's not much higher than the 23 percent growth being delivered by members of the Nasdaq Composite Index -- which is trading at 18 times earnings. Companies on the ChiNext, meanwhile, are still increasing revenue at a 44 percent pace.
Alibaba provides an indicator of the competitive pressures driving down growth for technology companies in a slowing economy. Far from "bucking the trend,'' as Executive Vice Chairman Joe Tsai told investors this month, Alibaba is increasing its top line at a slower and less profitable rate.
Alibaba and rivals including JD.com, Baidu, Tencent and VIPShop are jostling to steal shoppers and advertisers from each other while offering generous subsidies to lure consumers to new services. The result has been a 40 percent contraction in Alibaba's operating margin. JD.com, whose revenue is bigger and growing faster than Alibaba's, continues to post operating losses.
China stocks in the U.S. have been propped up by a stream of buyout offers motivated by hopes of relisting on a mainland exchange, where investors remain relatively more exuberant, at least for high-growth and technology companies. Yet even that pillar of support is being removed, with Chinese regulators set to close the door on these take-private deals. Beijing's efforts to curb capital outflows have also limited the funds available to back these transactions, as Gadfly's Nisha Gopalan and Andy Mukherjee wrote last week.
If there's any silver lining, it's that U.S.-listed Chinese companies are sitting on buckets of cash and haven't been shy about tapping debt markets to fund share buybacks. However, stock repurchases can only go so far to cover the cracks when underlying business conditions are deteriorating.
For a more sober take on the outlook for corporate profits in China, take a look at the Hang Seng China Enterprises Index of stocks traded in Hong Kong. That's currently trading on less than 7 times this year's estimated earnings, an almost 80 percent discount to the ChiNext. It's ironic that U.S. investors retain the exuberance of the frothiest market in the mainland. They need to catch up to the new normal.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
To contact the author of this story:
Tim Culpan in Taipei at firstname.lastname@example.org
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Matthew Brooker at email@example.com