Prudential Betting China Will Cut State Giants Down to Size

Prudential Plc is buying Chinese state-owned industrial companies on bets that government steps to boost their efficiency will pay off.

Overcapacity has damped earnings the past few years while driving down valuations, said Ken Wong of Eastspring Investments, which oversaw $115 billion as of June as the Asian asset-management arm of the U.K.’s largest insurer. That’s a recipe for the shares to climb once investors see more evidence of the enterprises benefiting from restructuring, he said.

Chinese President Xi Jinping is trying to revive the companies as the economy faces the weakest growth since 1990. Measures include opening well-known names such as PetroChina Co. and China Petroleum & Chemical Corp. to private investment and ordering cuts to excess output.

“Expectations are at their lowest already,” Wong, a client portfolio manager at Eastspring, said in an interview in Hong Kong on Nov. 6. “We think earnings can normalize and margins will improve, and those are going to be companies we would like to invest in. It doesn’t hurt us that a company has seen earnings or share prices falling 20, 30 or 40 percent.”

While the CSI 300 Industrials Index’s valuation has risen to 15.9 times reported profits as of yesterday from a June low of 10.6, the multiple is down from 28 in March 2010. Analysts predict earnings will climb 29 percent in the next 12 months, according to data compiled by Bloomberg. The MSCI World Industrials Index traded at a multiple of 17.8 yesterday.

The CSI 300 Industrials Index climbed 0.9 percent at the close today, while the Shanghai Composite Index added 2 percent. Eastspring’s Wong said he looks at specific stocks instead of buying the sector broadly, and declined to name his picks.

State Companies

State-owned Zoomlion Heavy Industry Science & Technology Co. plans to boost overseas sales through the New Silk Road plan for cutting domestic overcapacity, Shanghai Securities News reported this week, citing Zoomlion’s Senior President Zhang Jianguo. While the stock jumped 18 percent in Shenzhen from this year’s low in June through yesterday, it trades at 15.5 times estimated earnings, about 30 percent below its peak four years ago. Daqin Railway Co., a unit of state-owned China Railway Corp., is valued at 9.6 times projected profit even after surging 54 percent over the past five months.

China’s National Development and Reform Commission will release documents detailing changes for state-owned enterprises by year-end, China Securities Journal reported this month, citing people familiar with the matter. The government said in April it will open 80 projects in industries dominated by state-owned entities to private capital amid a push to give markets a bigger role in the allocation of resources.

Positive Potential

“Obviously everybody hopes the speed and the magnitude of improvement would be greater,” said Wong. “But if you look at what we see so far, SOEs now are starting to deleverage for the first time in four years.”

Eastspring said on Nov. 19 it purchased industrial shares at the start of the equity link between Hong Kong and Shanghai, which allows foreign investors greater access to China’s market. MSCI Inc. may include mainland shares in its global indexes after the start of the program, triggering passive buying by index funds, Wong said.

China unexpectedly cut benchmark interest rates for the first time in two years after data showed industrial production rose 7.7 percent in October from a year earlier, the second-slowest pace since 2009. Analysts surveyed by Bloomberg News expect the economy will grow 7.4 percent this year. The NDRC said this week China should set a lower expansion goal to allow reforms to take hold.

“The one problem in the market right now is that investors haven’t fully bought into SOE reforms,” said Wong. “Markets only start to rerate once people start believing.”

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