The magnitude of uncertainty in China’s politics and policy today is undeniably daunting. Western observers — and even the Chinese — simply do not know in what direction China’s new leader, Xi Jinping, will take the country or how constrained his policies will be by China’s increasingly powerful special interests. According to many market participants and economists, banking reform and the creation of more open capital markets are two important areas for China’s new leadership to tackle. But how high will these rank as priorities in the new regime? And how beholden will ascending leaders be to members of the older generation of party bosses, regional strongmen, and heads of state-owned enterprises? Due to the information vacuum that has enveloped this once-in-a-decade leadership succession, the world may feel boxed into a relatively speculative position when it comes to assessing the attractiveness of Chinese stocks.
However, with expectations low — even in the wake of recent strength — and with a fair share of uncertainty still priced into Chinese equities, we may have crossed an auspicious threshold for getting constructive on this important area of the global markets. Indeed, as Chinese rail investment reaccelerated in the second half of 2012 and tight property measures gradually loosened, Chinese macro data have continued to improve moderately, which lends support to the idea that China may not be a good candidate for more selling.
A deep value opportunity
In this regard, an illustration of the relative valuations of Chinese stocks speaks volumes. Today, Chinese stocks are trading below 2x book value — approximately two standard deviations cheap to their historical average price-to-book ratio. On this view, markets may have unfairly exaggerated the risks of Chinese companies.
For most of 2012, investors were willing to pay up for stocks, sectors, and countries less exposed to the gyrations of global growth expectations than China. Smaller, less-liquid markets in the ASEAN region (Association of Southeast Asian Nations, including Thailand, Malaysia, and Philippines), for example, meaningfully outperformed BRIC (Brazil, Russian, India, and China). As in developed markets, ASEAN defensives — which include telecommunications, staples, utilities and health-care stocks — generally outperformed both global cyclicals (materials, energy, and technology) and domestic cyclicals (financials, industrials, and consumer discretionary) for much of the year. But by the time of the U.S. presidential election in November 2012, ASEAN equities versus equities in BRIC were trading at all-time valuation highs.
Since November 2012, Chinese equities gained ground at a healthy clip. But for emerging-market investors who are still taking a hard look at China and its neighbors, meaningful valuation differences continue to be relevant. Coupled with the possibility of progressive policy developments and continued meaningful improvement in macroeconomic conditions, China could be perceived to be on better footing alongside its booming, smaller neighbors. While ASEAN markets enjoy the benefit of numerous tailwinds for growth, from strong policy support for agriculture in Thailand to momentum in Malaysian infrastructure, analysts need to sharpen their pencils to find better valuations there, as these are no longer obvious bets. As the political clouds begin to clear in China, the time may be ripe for reassessing opportunities for growth off what may prove to be a deeply discounted valuation floor.