China – time to buy?

China – time to buy?

From its peak in early February 2021, China’s share market went through a grinding three-year decline of 40 per cent, while over the same period the MSCI World index was up 20 per cent. When one of the world’s largest stock markets underperforms by 60 per cent it makes sense to see if there’s a bargain to be had.

Chart 1: there’s real money going into IT spending in the US

What’s happened to China?

The fabled China growth miracle hit a couple of huge speed bumps in the form of COVID and a serious shakeout in the property sector.

In the six years to the end of 2019, China’s annualised GDP growth rate declined in a very smooth, if not controlled, path from a ridiculously high 7.5 per cent to a still astonishing 5.8 per cent. Then COVID wreaked havoc. Between stringent lockdowns and the government’s refusal to make similar fiscal injections as western governments, the Chinese economy didn’t bounce out of COVID in the same way Australia and the US.

Chart 2: the S&P 500’s PE ratio with and without the MegaCap 8

The COVID slowdown triggered an almighty reckoning in the property market, which accounted for a whopping 30 per cent of China’s GDP in 2022. The government finally tried to deflate a classic speculative property bubble, which led to two of the biggest property developers in China, Evergrande and Country Gardens, which between them had more than USD520 billion of debt, spiralling toward oblivion.

Recent data showed housing starts in China fell 30 per cent year on year and completions were down 20 per cent, while sales dropped 21 per cent and property values got crunched by 29 per cent.

While those numbers are very messy, the government was determined to avoid the banking catastrophe the US experienced in 2008. Dr Joseph Lai, of Ox Capital, reckons that although there will be significant bad debts, they appear to have already peaked and the banking system has proven to be resilient.

Positive signs?

There was general surprise when China’s 2023 GDP growth came in a bit better than expected at 5.2 per cent, and Citibank notes the February data contained some positive signals, with industrial production rising 7 per cent year on year, in stark contrast to the US where it was slightly negative over 12 months.

Investment was also “way higher than consensus”, with manufacturing investment up an impressive 9 per cent for the first two months of the year and infrastructure 6 per cent, much of it actively encouraged by Beijing as a way of reducing the economy’s dependence on property.

The government is actively promoting decarbonisation industries, with the usual head spinning results you get when China puts its mind to something. For example, electric vehicle production has risen about seven-fold from pre-COVID levels, and now China produces about one-quarter of the world’s EVs and accounts for more than half of registered EVs worldwide. Similarly, solar battery production has risen more than three-fold and it accounts for more than 80 per cent of global solar cell exports and 50 per cent of lithium batteries.

The santa claus rally

Although the critical consumer sector is still not as optimistic as it was pre-COVID, retail sales rose a healthy 5.5 per cent compared to a year ago.

The share market

If share markets directly reflected economic growth, the Chinese share market would have been the world’s biggest a long time ago. The fact is, economic growth can be generated by government spending that doesn’t necessarily benefit private companies, or come from sectors that aren’t represented in the index.

Having said that, the Chinese market does look cheap. After that 40 per cent crash and bottoming in early February, the CSI 300 bounced more than 13 per cent in seven weeks, but at a time when markets across the world are hitting new all-time highs, China is still 38 per cent away from theirs. That bounce caught the attention of a lot of technical analysts, but consensus is that it’s still early days given there have been false starts over the past couple of years.

Aggregate weekly payrolls deflated by PCE inflation

China’s price to earnings ratio for the next year snuck below 10x and is still about half the US’s and way below Australia’s 17x, while earnings growth over the next year is forecast to be about 14 per cent, compared to Australia’s very pedestrian 0-3 per cent.

All eyes will be watching for signs the Chinese government will increase its support for either the economy, or the share market, or both. There had been hopes the government would repeat the massive spending package of 2008 that helped drag the world out of the GFC, but it never came. There has been some easing of borrowing rates and ham-fisted restrictions on selling Chinese stocks by local financial institutions, but no killer package.

There is no telling if the Chinese stock market crash is over, but smart investors know that in carnage can lie opportunity. For those looking to access China, VanEck has two ETFs listed on the ASX: CETF invests in the 50 largest mainland companies, and CNEW uses an algorithm to invest in 120 quality companies across IT, healthcare, consumer staples and consumer discretionary.

A contrarian opportunity in small caps

A contrarian opportunity in small caps

Contrarian investing is always difficult because, by definition, it requires swimming against the tide, which can be uncomfortable and tiring. While it’s certainly not for everyone, it is often where the best value and opportunity is to be found. Small cap companies in Australia and the United States may well be offering that opportunity right now.

Since the Australian share market peaked back in August 2021, the Small Ordinaries Index (XSO) has copped a way harder beating than its large cap peers falling by more than 20 per cent over the course of the market correction, while the ASX100, made up of the 100 largest companies on the Australian stock exchange, has dropped by only 5 per cent.

For a bit of longer-term perspective, the returns from XSO relative to the top 100 stocks is more than 20 per cent below its 20-year average, or more than 1.5 standard deviations. That is only 5 per cent away from its lowest level in at least the last 30 years – see chart 1.


The relative performance of the Small Ords<br />
vs the ASX100 is at a multi-year low

Similarly, the Russell 2000 (R2K) index of US small cap stocks has taken a similar beating during this market correction and is still down 22 per cent from the market’s high at the end of 2021. After tracking the large cap S&P500 for most of that time, over the past two months the performance gap is now the widest it’s been over that 17-month period.

Again, however, for some longer-term perspective, after the recent AI-driven rally in the mega cap tech stocks, the R2K’s returns relative to the S&P500 is about 27 per cent, or almost two standard deviations, below its 20-year average.

What is of far greater significance, though, is the valuation gap that’s opened up between US small cap companies and their large cap peers. When you compare their PE ratios, small caps are the cheapest they’ve been versus large cap stocks for well over 20 years and are now 2.5 standard deviations below the 20-year average – see chart 2, putting it in the 99th percentile.

US small caps are as cheap as they’ve<br />
been vs large caps for at least 20 years<br />

Luke McMillan, Head of Research for one of Australia’s best performing small cap fund managers, Ophir, points out that, unlike the GFC where markets fell because earnings collapsed, the current market correction is largely due to investor sentiment turning sharply negative, which gets reflected in a drop in the PE (price to earnings) ratio.

Not unusually, when the market experiences a sentiment driven correction, referred to as ‘PE compression’, small caps companies get hit harder than large caps as investors opt for the perceived safety of bigger companies.

And that can be the rub with investing in small cap companies. While it’s easy to get excited by the runaway small cap success stories that made early investors rich, like Afterpay or REA Group, there are far more stories of investors that have either lost everything or have watched their investments go nowhere year after year. The annualised volatility of the Small Ordinaries index is 25 per cent higher than the ASX100, in other words, investors need to be prepared to buckle up for a bumpy ride.

Many small cap companies have either no analysts covering them or very few, so getting your hands on reliable information can be difficult, especially if the company’s based overseas. That can make for great opportunities for those investors capable of picking apart a cash flow statement and balance sheet, and who are prepared to put in the time and effort to get to know a company in detail and spot the gems before the crowd. But, as McMillan says, a great small cap company needs a lot more than a good story; smart management and strong financials are critical.

While fund managers can find it a real challenge to beat large cap indices, making passive investing via an ETF an attractive option, because of the huge dispersion between profitable and loss-making small caps, it’s usually much easier for a good manager to beat the small cap index. The trick is finding those good managers.

The final thing any smart investor needs to remember when investing in a riskier asset like small caps, is to size the investment appropriately for both their portfolio and, importantly, their risk appetite.