By
Kevin
O'Brien
:
China's GDP growth does not translate into Chinese share
performance as China's state-dominated and investment-led GDP
growth policy continues squeezing the Chinese corporate sector's
profitability, causing a decoupling in share price performance
relative to China's GDP growth. This trend is exacerbated by
declining manufacturing activity (see
here
and
here
) and poor corporate audit standards, which belie the 'China growth
story' and conspire to create a classic value trap for investors in
Chinese equities.
U.S. and European Indices
Have Consistently Outperformed the Shanghai Composite
Despite the enduring European Union fiscal crisis, China's Shanghai
Composite consistently underperforms both the U.S. and European
markets as China's political economy, with its emphasis on
non-economic investment-led growth, continues to marginalize the
profitability of exchange-listed companies, rendering the country's
stock markets unappealing to foreign investors. The government's
investment policies act to constrain private equity investment
since the domestic stock market fails to deliver an attractive exit
option in terms of equity valuation. As a consequence, stakeholders
in private enterprises are increasingly likely to seek a buyout
from a Chinese state-owned enterprise or joint-venture partner in
order to exit illiquid investments.
The SSE Composite Index does not capture exposure to China's
national GDP growth. As noted above, the likely explanation is that
as both the central government and local governments continue to
allocate resources into investment in non-revenue generating
fixed-asset infrastructure projects as an economic substitute for
the lack of domestic consumption, and which projects do not cover
the cost of funding, the country is propagating the destruction of
economic value even as GDP increases. In China, GDP is calculated
on the basis of funds expended, versus economic value produced (as
in the West). The resulting overcapacity constrains investment by
the private sector, as well as revenues. The continuation of
directed investment by the state-owned corporate sector will
generate GDP, but in the process will create ever-increasing
overcapacity and thus diminishing return on investment. Ultimately,
both state-owned and private sector corporate profits will achieve
a negative value, even as the country maintains an 8% annual GDP
growth mandate. Thus, Chinese equities fail to provide investors
with economic returns which are commensurate with China's overall
GDP growth, and so despite the U.S. and European road shows by
Shanghai Stock exchange officials and fast-tracking approvals of
Qualified Foreign Institutional Investor (QFII) applications,
China's stock market will continue to disappoint.
Hong Kong-listed Chinese companies have issued a record number
of profit warnings during 2012, surpassing the peak reached during
the height of the 2008-2009 financial crisis, and the rate of such
warnings continues to increase. The fact that corporate
profitability is shrinking even as China's GDP continues to
increase (predominantly as a function of state-directed
non-economic investment) further strengthens the evidence for a
decoupling between corporate profitability and China's
macroeconomic growth and thus confirms the thesis that China's
stock market does not provide investors with the means to capture
exposure to China's macroeconomic growth story.
Related Information
Sovereign Advisers, Inc. has researched a
Special Report on the Future of the Chinese
Economy
, which addresses several developing trend-lines affecting the
direction of China's economic outlook. Sections of the report
include the following topics:
●
Audit Standards
China's lack of a strict regime for corporate auditor standards
has contributed to numerous instances of alleged and proven frauds
involving overseas exchange-listed Chinese companies, including
reports of a mainland China investment bank which allegedly
specializes in counseling private Chinese companies in obtaining
fraudulent listings on overseas stock exchanges. A litany of
"reverse merger" and exchange-listed corporate frauds is exposed in
the section of the report which addresses "Exchange-Listed Chinese
Company Fraud."
●
Frontier Hedge Funds: Emerging Perspectives on
China
A dramatic shift in perspectives on China by leading hedge funds
is underway, as characterized by David Einhorn's statement at the
2012 Ira Sohn Investment Conference in New York that "China is
misunderstood and is not an investment opportunity." The various
rationales underlying this trend are described in the section of
the report entitled, "Global Macroeconomic Hedge Funds: Emerging
Perspectives on China."
●
Dependency on Fixed-Asset Investment
Massive stimulus program and recently announced second, even
larger stimulus program. Unsustainable, as noted by Dr. Larry Lang,
Chair of the finance department at the Chinese University of Hong
Kong, who stated during a speech before an audience in Shenyang
City in northern Liaoning Province on October 22, 2011 that the
Chinese regime was in a serious economic crisis and on the brink of
bankruptcy, stating "in China, every province is a Greece." The
results associated with government stimulus-funded GDP 'growth' are
described in the following two sections of the report entitled,
"Non-Economic Fixed-Asset Investment" and "Satellite and Surface
Images of the Vacant Ghost Cities of China."
●
Shadow Banking System
The economic consequences attributable to expansion of the
unsupervised and unregulated Chinese shadow banking system,
including an unprecedented surge in local government debt and
leveraged property speculation, are exposed in the section of the
report entitled, "China's Shadow Banking System."
Click to access the
Special Report on the Future of the Chinese
Economy
Disclosure:
I have no positions in any stocks mentioned, and no plans to
initiate any positions within the next 72 hours. I wrote this
article myself, and it expresses my own opinions. I am not
receiving compensation for it. I have no business relationship with
any company whose stock is mentioned in this article.
See also
Reality Check: Analyzing Earnings Season So Far And
Looking Cautiously Ahead
on seekingalpha.com