I have been looking at a very useful report prepared by Edmond Huang, of UBS, on the Chinese stock markets. A couple of things occurred to me.
1. According to the report, the trailing PE ratio for Chinese A-shares is around 44. The forward PE ratio is 33. Huang told me that the forward PE is based on projected earnings for the next twelve months, whereas the trailing is based on the reported earnings for the previous twelve months.
Are these PE ratios justified? They seem high compared, for example, to US PE ratios, but if you expect profits for Chinese companies to grow at a faster rate than for non-Chinese companies, they might not be. It depends on what the expected relative growth rate is. I tried to answer this question in a different way. If we assumed that Chinese companies were growing at different relative rates than US companies, what would the equivalent US PE be?
My quick and dirty answer is that if we assume that Chinese corporate profits are growing at 1.5 times the rate of US corporate profits over the next thirty years, and then grow at the same rate, a 33 forward PE in China is equivalent to around 19-22 PE in the US (depending on what you think US growth rates are).
If we assume that Chinese corporate profits are growing at 1.2 times the rate of US corporate profits, a 33 Chinese forward PE is roughly the equivalent of a US forward PE of 25-28. Finally if we assume that Chinese corporate profits grow at 2 times the rate of US corporate profits, the forward PE equivalent is 16-19.
Since China's GDP growth is expected to be twice that of the US for the foreseeable future, these numbers are not outrageously optimistic, even if you are concerned about the quality of growth.
Obviously we cannot compare PEs directly because the US market is much more stable and diversified, and US companies have higher quality earnings and financial data. Still, these numbers suggest that Chinese PEs aren't as crazy as one might have thought, especially given the very low interest rates and limited investment alternatives available to Chinese.
2. The second point is about the value of B-shares. Chinese companies have issued both A-shares, which can only be purchased by Chinese citizens, or by foreigners through the QFII scheme, and B-shares, which can be purchased by anyone who has US dollars (Shanghai) or HK dollars (Shenzhen). In principle B-shares are equivalent to their A-share counterparts, have equivalent claims on earnings, and will converge at some point when China removes capital controls (although not necessarily one for one). The B-share market is tiny. Total A-share market cap is about $2.8 trillion, with B-shares only adding up to about $60 billion.
Because the market is so illiquid (and perhaps because most Chinese retail investors find it complex or confusing), B-shares trade at a steep discount to A-shares. According to Edmond Huang, they currently trade at a 42% discount. For the last six years they have traded in a discount range of 30-50%.
This implies a B-share trailing PE of 26 and a forward PE of 19. Adjust them further for the higher expected growth rates, and the US-equivalent PE for B-shares might be as low as 10-15.
Michael Pettis is a professor at Peking University's Guanghua School of Management, where he specializes in Chinese financial markets. He has also taught, from 2002 to 2004, at Tsinghua University’s School of Economics and Management and, from 1992 to 2001, at Columbia University’s Graduate School of Business. He is a member of the board of directors of ABC-CA Fund Management Co., a Sino-French joint venture based in Shanghai.
Pettis has worked on Wall Street in trading, capital markets, and corporate finance since 1987, when he joined the Sovereign Debt trading team at Manufacturers Hanover (now JP Morgan). Most recently, from 1996 to 2001, Pettis worked at Bear Stearns, where he was Managing Director-Principal heading the Latin American Capital Markets and the Liability Management groups. He has also worked as a partner in a merchant banking boutique that specialized in securitizing Latin American assets and at Credit Suisse First Boston, where he headed the emerging markets trading team. Besides trading and capital markets, Pettis has been involved in sovereign advisory work, including for the Mexican government on the privatization of its banking system, the Republic of Macedonia on the restructuring of its international bank debt, and the South Korean Ministry of Finance on the restructuring of the country’s commercial bank debt.
Pettis is a member of the Institute of Latin American Studies Advisory Board at Columbia University as well as the Dean’s Advisory Board at the School of Public and International Affairs. He is the author of several books, including The Volatility Machine: Emerging Economies and the Threat of Financial Collapse (Oxford University Press, 2001). He received an MBA in Finance in 1984 and an MIA in Development Economics in 1981, both from Columbia University.
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January, 2008
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