Chinese Equities Are Dirt Cheap And Due For A Re-Rating - Barclays

Tom Burroughes

8 October 2014

Chinese stocks are cheap in relative and absolute terms – at a discount of around 45 per cent to US equities – and about 20 per cent cheaper than in Asian markets overall, but equities are set for a re-rating as the country pushes to reform its economy, argues.

In its quarterly Compass report, Barclays’ wealth and investment arm takes a relatively optimistic view that moves by China to shift its economy towards more consumer-driven growth, and chip away at the privileges of state-run firms, will bear fruit.

“China’s growth story may be on the wane, but its equity markets still look a good bet as the central government’s plan for economic modernisation takes hold. Cheap valuations provide an attractive strategic entry point for investors who are able to withstand the near-term volatility prompted by the overhaul. Investing in sectors that are likely to profit from reform initiatives may be a valid interim strategy,” it says.

“From a valuations perspective, Chinese equities are cheap, on both an absolute and relative basis. The broad index is trading at a price-to-book ratio of 1.5 – around 32 per cent below the 10-year historical average – and at a 45 per cent discount to US equities,” it said.

It continued: “Within the emerging markets universe, Chinese stocks are one of the most oversold (though not to the extent of Russia) and currently 20 per cent cheaper than their Asian counterparts. These valuations, while attractive on the surface, are somewhat skewed by the deeply-discounted banking sector.”

Barclays said moves by the Communist-led country to rebalance the economy may result in a structural re-rating of the overall equity market: “a more sustainable growth outlook would alleviate the negative sentiment towards Chinese assets, therefore causing risk premiums to fall”.

The bank said there are signs that banks are tackling the issue of nonperforming loans through asset sales, capital raising and renewed dealings with “bad banks”. It says the forthcoming introduction of deposit insurance is also likely to provide some stability to the financial system, pushing sector valuations higher.

Some recent weakness in Chinese economic issues has weighed on the Chinese stock market – the MSCI China index of equities has fallen by over 9 per cent since early September. But forthcoming developments should be positive, Barclays says, such as the Hong Kong-Shanghai stock market link (the “through-train”).

“The slowdown in China is not indicative of a deteriorating economy, but a by-product of a much needed transition from an investment-led, commodity-intensive growth model to one that is more consumption oriented. Enacting the reform blueprint – and enabling an economic overhaul – would not only improve the quality, but also the long-term sustainability, of growth. The shift in sentiment, added to the realisation that quality supersedes quantity, may improve the outlook for earnings and steer prices higher,” Barclays says.

“The re-rating process is likely to be gradual, but factoring in all the above elements, the strategic case for China remains in place. Successful reform implementation will be the catalyst for unlocking value in Chinese stocks, though it is difficult to gauge the exact timing of this. At this juncture, equity markets in China remain an attractive opportunity for those investors with a long-run investment horizon and willingness to overlook near-term volatility,” it adds.