China's stock market favours foxes over hedgehogs

Reuters

2 days ago

LONDON, May 29 (Reuters Breakingviews) - 'The fox knows many things, but the hedgehog knows one big thing.' The famous adage of the ancient Greek poet Archilochus is reflected in investors' deeply contrasting attitudes towards China's stock market. Over the past year, the foxes, who have a trading mentality, have been riding a rally in Chinese equities. Hedgehogs have stayed away. The one thing they know is that the People's Republic is no place for long-term investors.
Over the past decade, U.S. stocks have trounced Chinese equities. That order has reversed this year. Since the beginning of January, the S&P 500 Index (.SPX), opens new tab is basically flat while the MSCI China Index (.dMICN00000PUS), opens new tab, which includes mainland companies listed in Hong Kong and New York, has climbed over 10%. On the surface there's plenty for investors to get excited about. Chinese companies remain ultracompetitive, as evidenced by the country's massive trade surplus. The People's Republic boasts several world-class firms, including tech giant Tencent and carmaker BYD. It also dominates cutting-edge technologies from electric vehicles to battery storage.
Viewed over a longer period, Chinese equities have profoundly disappointed. Since the re-establishment of the country's stock market in the early 1990s, they have returned a mere 3.3% a year after inflation, according to UBS. That's just half the average long run historic return of the U.S. stock market, and in line with the return on Chinese bonds. The country's stocks look relatively cheap at 15 times cyclically adjusted earnings, less than half the level of their U.S. counterparts. But Chinese equities traded at a similar valuation 10 years ago.
What explains the systematically low returns from Chinese stocks? In his recently published book 'The Making of Modern Corporate Finance, opens new tab', the author and consultant Donald Chew argues that China has adopted the form of Western financial practices - stock exchanges, regulators, brokers, and auditors - but not their substance. Chinese companies and investors operate without the strict rule of law or strong property rights. Beijing views the stock market primarily as a place to raise cheap capital rather than reward those who provide it, says Chew. There's no market for corporate control in China. Minority shareholders have little influence.
Listed Chinese companies have low profit margins and sluggish asset turnover. Over the past decade, their returns on equity have fallen from 10% to 6%, according to Gillem Tulloch, founder of Hong-Kong based GMT Research. A recent paper, opens new tab by Ben Inker and Anna Chetoukhina of the Boston-based investment firm GMO finds that the mildly negative annual returns on Chinese stocks in the decade between September 2014 and September 2024 were due to deteriorating fundamentals and significant shareholder dilution. The issuance of additional stock lowered returns by 2.6% a year over this period, according to GMO.
The addition of several highly valued tech companies, such as Alibaba and Baidu, to the MSCI China Index provided an additional drag. Chinese stocks deserve a steep discount to other markets because companies reinvest close to 100% of their profits at structurally low returns, GMO concludes.
Future changes to the MSCI China Index may not to be so damaging to investors while the decline in returns on capital could turn out to be a cyclical phenomenon. After all, investors were put off by years of lacklustre returns from Japanese stocks until former Prime Minister Shinzo Abe instituted a series of reforms after returning to power in 2012. Since then, the Nikkei 225 Index (.N225), opens new tab has more than trebled.
Chinese authorities last year tried to revive the stock market as part of efforts to stimulate the world's second-largest economy. There's little evidence, however, that President Xi Jinping is a convert to shareholder value. If anything, he has moved corporate China in the opposite direction. Public companies are expected to conform to Xi's vision of 'common prosperity', which means avoiding supposed capitalist 'excesses' and following the Communist Party's priorities.
State-owned enterprises, which account for around half the Chinese market's capitalisation, are cogs in the party's machine. Their resources are often allocated at the government's behest. For instance, when Beijing launched its massive stimulus programme in late 2008, the biggest listed banks provided much of the credit, while many other SOEs became involved in supporting the property market.
Private Chinese companies regularly face pressure to support the government's priorities. Business leaders who step out of line, as Alibaba founder Jack Ma did in October 2020 when he publicly criticised Chinese financial regulators, face repercussions. Companies that operate in sectors that have fallen out of favour with Beijing are liable to be crushed, as investors in private education providers discovered in 2021.
Although the epidemic of corporate fraud that erupted in the early 2010s has abated, Chinese financial statements are the least reliable in Asia, says Tulloch. Company research provided by analysts based on the mainland is also of low quality, he says. The risk factors listed in Chinese IPO prospectuses are watered down to comply with rules banning comments that disparage government policies or the business environment, argues Ian Williams in his book 'Vampire State: The Rise and Fall of the Chinese Economy", opens new tab.
Despite the Chinese stock market's lacklustre returns over the past 15 years, investors have had opportunities to make money. During this period there have been several strong market rallies, including two full-blown bubbles, starting in 2014 and 2020.
The trick for investors is to front-run those rallies by gauging when Beijing is poised to support the market. That's what happened last year, when the People's Bank of China lowered the reserve requirement for banks and set up a stock market lending facility. The securities regulator banned short sales. Large shareholders were instructed not to sell shares and state-owned entities stepped in to support the market. More recently, Chinese tech stocks have benefitted from optimism about advances in artificial intelligence.
Speculative foxes who anticipated these moves are licking their chops. They should not overstay their welcome. Hedgehogs believe that foreign investors in China face similar risks to those operating, until recently, in neighbouring Russia. In their view, Chinese stocks are only ever a trade and not an investment.
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