Sentiment towards Chinese stocks is at a low ebb. Poisonous even. And with reason: Beijing’s regulatory stance has hardened against certain business practices, the property market is under a cloud and, for good measure, growth stocks have taken a clobbering as investors worry over rising interest rates. The fall from grace has been well documented by ourselves and others. However, we believe this negativity goes well beyond the likely outcome: investors are not taking notice of what the savage share price declines have done to valuations of high-quality Chinese companies whose businesses continue to do well.
Part of the reason why investors have lost sight of valuations is that many of the larger Chinese corporates did so well in 2020 and as a result, the hangover was inevitable last year. Tencent is a good example. It is still a leading growth business which has the potential to pump out 20% per annum in revenue growth. When China stayed at home in 2020 and played video games, that jumped up to 28%, and earnings spiked accordingly. As things normalised in 2021, growth slowed below trend with the usual disproportionate impact on earnings, while regulatory interference merely exacerbated this trend.
As we look to the outlook for 2022, this situation is inverted: 2021 is now a low base for comparison. For Tencent, that means a return to around 20% growth, for which you are asked to pay little more than 1x PEG. Not to mention the prodigious cashflow (around $35bn free cash flow per annum) and potential for asset realisation from its huge investment portfolio.
For some in our portfolio, the growth trajectory has seen no impact from the broader slowdown. Li Ning is one such example, where if anything growth expectations have continued to rise. Li Ning had a very strong 2021, but we still expect around 32% and 28% growth in earnings over the next two years. The share price has corrected 30% in the past few months and is now also on a very attractive 1x PEG.
Many of our smaller China holdings are now even more attractively priced than the examples above, such that the China portion of the portfolio has a median PEG of just 0.7x.
Several of the high-profile internet companies have announced redundancies and retrenchment of late. It is a sign of private sector entrepreneurs doing what they do best in tough times: looking after the bottom line. We saw this in India in the first lockdown and those lower cost bases are now the source of much of the extraordinary profit growth seen since.
It is more than reasonable to expect a similar rebound in China. As ever it will depend on the companies themselves: some may never recover (education), but others will certainly recover and continue to thrive (online healthcare, entertainment, delivery and convenience services, healthy living, wealth management).
In summary, we believe many of the major headwinds for the Chinese stock market are either dissipating, or now largely reflected in share prices, or both. But while the rest of the world is mithering over interest rate rises, China is actually cutting them. We believe that other forms of government support will also be forthcoming. Timing of course will be critical but there is a clear fundamental argument for the long term investor to be adding to his/her exposure.
To us, the year of the Tiger looks much more promising than the outgoing Ox.
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