Chinese stocks have started the year strongly, continuing the trend of the last two months of 2014. Meanwhile other Asian markets are in the firing line, hurt by the weakness of the Yen because of the competition for exports and the strength of the dollar, because of the consequent capital withdrawal process. Chinese stocks are flagging as expensive in OTAS on a two year view, but how expensive are they really given the tremendous firepower that the authorities can bring to offsetting global macro trends?
The OTAS Stamps above are for a watchlist of over 250 Chinese listed stocks (mainland listed where available, otherwise H shares). Red warning flags are raised for Valuation, Dividend Yield and Director Dealings. The forward PE of 16.6x is very significantly above the average for the past two years, as there have been no net EPS upgrades over the past three months, while stock prices have rallied strongly during that period. However, over the long term, the current valuation is only mid range and has just exceeded the level of mid May 2011.
This history is influenced by the exceptional valuation reached in 2007, but the upper dashed line, representing one standard deviation above the long run average and the upper bound of the normal range, is currently a little over 23x, last reached in December 2009, and still 40% above the current level.
The strong performance in China reflects the depths from where the stocks have risen. The chart below shows the relative valuation of our index of Chinese stocks and the Russell 1000 in the US. This is almost at parity, which is a two year high, but longer term has only just crept back into the average range. PE is an indication of expected earnings growth and hence the market with the forecast fastest EPS growth should trade at a premium rating (EPS Momentum is slightly negative across the Russell 1000, as it is for the average Chinese stock).
This pattern in the relative valuation of China is very similar when we compare with Australian stocks rather than US. The performance against Japanese stocks is only marginally more advanced, but had not fallen to the depths of the relative performance against the other two markets. However, it is against Hong Kong that the valuation of Chinese stocks is potentially most frequently judged and there is a much more defined move in this relationship.
Chinese stocks trade at a 29% premium to the average HSI constituent, a level fast approaching the upper reach of the normal range, which is at a 30% premium. This level has not been exceeded since early 2009 and was surpassed arguably only in times of bubbles in Chinese shares.
As the pronounced rally in Chinese shares has not corresponded with earnings upgrades to date, it is perhaps of little surprise that the dividend yield on the average share has fallen from significantly high levels back into normal territory. However, compared with a long history as opposed to two years shown on OTAS Stamps, yield is nowhere near the low levels of the last ten years.
The net director selling of $376m over the past month may raise a few eyebrows, but the bulk of this is a $316m sale at China Minsheng Bank by Liu Yong Hao, whose net wealth is estimated by Forbes to be $3.7bn. There are a number of other shares, such as Sany Heavy Industry, China Vanke, ZTE, Weichai Power, Huayi Brothers Media, Beijing SL Pharmaceutical, Risesun Real Estate and Zejiang Dahua Technology, where sales have reached multi-million dollar levels. While net sales are barely half the level in the S&P 500, December selling is on a par with June 2007, which is not the case in the US.
Thus we may conclude that while from a historic perspective there is plenty of room for Chinese shares and valuation to continue to rally, insiders appear sceptical of the rally, which to date has no backing from higher earnings estimates.