After a troubling January, China** is in a difficult situation. Hong Kong's Hang Seng Index is down nearly 10 percent and is now trading at the same level as it was in 1997, when two major members, Tencent and Alibaba, had not yet been formed, and Hong Kong had just returned to Chinese territory.
At a recent conference in the city, more than 40% of participants claimed that China** is "uninvestable". Strategists complained that managers had stopped listening, while frustrated mainland investors began complaining on the U.S. Embassy's social media accounts in hopes of evading censorship.
A generational loss of returns, market fatigue and the "uninvestable" spell – sounds like an opportunity. Value trading requires enough haze to keep the market** down below intrinsic value, and there is no shortage of pessimism in the Chinese market. The question is whether this is a value deal or a value trap. To be the former, two things need to happen.
First, companies must act as they currently are: an unfashionable discount product that needs to market itself with tangible results, not a vague promise of future growth. Specifically, Chinese companies will need to rebuild investor confidence through buybacks and dividends.
Second, Chinese mainland investors must rebuild trust in the market. Foreign buyers are likely to follow the recovery. But they can't dominate.
Looking at valuations alone, there is no doubt that China** is one of the most attractive assets in the global market. According to Deutsche Bank, the Hang Seng Index has a forward price-to-earnings ratio of about 8x, which means that you pay $8 and get about $1 in annual revenue, while the global** valuation is more than double that figure. Its price-to-book ratio is below 1.
These are not failed companies. Large companies such as Tencent and Alibaba, which are highly liquid and still growing. They have a forward P/E ratio of 8 to 13 times and a healthy free cash flow yield, indicating that they are generating sufficient cash flow after meeting investment needs. If these companies return to trading levels in line with their U.S. counterparts, investor returns can comfortably double overnight.
There are two reasons for this low valuation. First, there are a number of factors that have undermined investor confidence in the future profitability of Chinese companies: a weak economic recovery, which has hampered revenue and profit growth in the short term, and a regulatory crackdown in Beijing that has reset perceptions of profit potential in many sectors. To the extent that investment opportunities in companies operating in these industries have diminished, these companies should be giving cash back to investors, and in a sense they are doing so. Last year, both Tencent and Alibaba made dividend payments and buybacks.
Beijing is slowly relaxing. More financial support will be provided for the economy this year, and clearer rules will be set in areas such as online gaming. Fundamentally, China's economy still has a lot of room to grow, which should be good for corporate earnings.
The more difficult issue is geopolitics. Geopolitics has no direct impact on corporate profits in most cases: tensions over Taiwan will not stop players of Tencent** games or shoppers of Alibaba***. Rather, it creates an incalculable risk that at some point in the future, international investors will be arbitrarily deprived of access to their income**. This is what happened when Russia invaded Ukraine. Naturally, investors will pay less for an income stream that may suddenly disappear.
At the moment, it is unrealistic to remove this discount by reducing geopolitical tensions. However, this discount can be particularly severe when the company retains its earnings for internal investments, in which case all potential cash flows belong to the distant, uncertain future. By making buybacks and dividends, Chinese companies can make these cash flows more immediate, more certain, and therefore more valuable.
But geopolitical risks still create an inevitable divide between the value of China** between international and domestic investors – international investors face the risk of confiscation. Recovery will only come when domestic investors regain their interest in what used to their detriment.
Signs of official intervention made **on Tuesday**, but the state-backed purchases of the "national team" will not generate a sustained recovery. More promisingly, the agency in charge of state-owned enterprises decided to start evaluating managers based on the performance of their listed units, while regulators pushed for dividends, buybacks, and faster delisting discipline for issuers who violated the rules.
Chinese investors rightly question whether the market will work in their interest, but with the property sector unlikely to recover anytime soon and capital controls still very strict, they lack other places to put their money.
The recovery of the Chinese market, based on the return of cash to investors, will be a painful drug for some companies that seemed poised to conquer the world a decade ago, but it will make the value deal happen – giving foreign investors one last chance to withdraw their cash.
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