China stocks still very rich

From Bernstein via FTAlphaville:

The rebound over the last week means we have entered a period where everyone was right. China bulls can argue that the Shanghai Composite is still up 94% over the last twelve months. China bears can argue that the Chinese regulators have effectively taken the market out of consideration by virtue of the ham-fisted approach to reversing the sell-off. However, “I told you so” doesn’t constitute an investment recommendation.

…At one point early this month, the only natural level of support for the Shanghai Composite was zero. The decision of 1,000+ Shanghai- and Shenzhen-listed stocks to suspend trading (rather than take their drubbing) and the decision by the China Securities Regulatory Commission to start firing off instructions to market participants was either a breach of the CSRC’s duty to regulate – rather than try to control the market or the only option available given the proverbial rush for the exits. Regardless of your view, the tactic seemed to work. The difference between desperate and decisive is efficacy. But what now?

The Shanghai Composite still consists of a large number of suspended companies (132 last Friday, representing 12% of the index) and, for various reasons, a large number of trapped investors. It’s true that Shanghai now trades at only 16.3x forward earnings versus 16.1x for the S&P500, for example. However, exclude financials and the Shanghai Composite is trading at 26x forward earnings. Because of the over-representation of low growth and low ROIC sectors within the Shanghai Composite (banking, industrials), it arguably should trade at a significant discount to other global indices. The “growth” parts of the Shanghai Composite are still trading at much higher multiples. If the Shanghai Composite industry weightings were identical to those of the S&P 500, Shanghai would be trading at 27x, even today. In addition, foreign investors are going to take their time in re-engaging given the volatility of the market and the unpredictability of the regulator. We would avoid the Shanghai market for now.

…There is something artificial about assuming that the gauges that were useful leading into the last selloff are going to be of any use next time. Of course, given the unusual manner in which the most recent selloff in China ended (through government intervention and suspension of trading, rather than through price discovery at distressed valuations), arguably the factors that drove weak performance in June and early July are still relevant. In short, there is always the risk that – whatever the last six weeks ends up being remembered as – it isn’t over.

We remain broadly positive on China. The recent sell-off was – in our view – a market event, not the start of an economic or financial crisis. However, valuation – even after the sell-off means that if you want to buy Shanghai as a way to gain exposure to China, just buy the banks. Of course, if you are going to do that, the banks are cheaper in Hong Kong.