Investors should steer clear of China-listed stocks, says Schroders head of Asian equities King Fuei Lee.
Bronze Rated fund manager Lee is cautious about Asian stock markets as a whole – but particularly bearish about China.
“Three quarters of the MSCI China index is made up of banks and state owned enterprises. These companies’ structural profitability is challenged in my view, due to high levels of debt and poor cash flow,” he said.
“The remaining quarter of the index is overpriced, and regardless of China’s economic backdrop if valuations are too high I will not buy a stock.”
Included in this over-priced quarter is the success story of last year – Macau gaming companies. The average share price in the Macau gaming sector doubled in price over the 12 months to February 2014, but has since come off the boil. Lee drew comparisons with the NASDAQ index in the run up to the tech bubble bursting in February 2000.
“Macau gaming stocks have experienced a correction this year, and many people are viewing this as a buying opportunity, but I think this is the beginning of a slow decline,” he said.
“Unlike the NASDAQ during the tech bubble, gaming stocks do have real earnings, but the valuations are similar which means the likelihood of a correction is high. Plus I question the sustainability of the stocks’ profits – once the Chinese government sees the revenue streams these companies have they will want a slice of the pie and I predict gaming licenses will be more expensive to renew.”
Lee says that China faces two main structural problems, that companies have over spent – and that this capital expenditure has been fuelled by credit.
Over the past seven years Chinese companies have borrowed enough to boost debt as a proportion of GDP by 87%. As a comparison, during the UK’s boom years to the 2007 credit crisis, our debt as a percentage of GDP rose by 50%.
Total outstanding debt as a percentage of GDP owed by companies is around 160% - but this is just the figure loaned out by banks. If you include the shadow banking system the number jumps to 200%.
There is an argument that as state owned enterprises make up such a sizable proportion of the over-leveraged borrowers, this debt can simply be wiped off the books – as both the lender and the borrower are one and the same. But Lee points out that even at the top of the credit bubble Chinese corporates are cash flow negative – meaning if things get tricky their ability to reply on cash flow is limited.
Neptune China fund manager Doug Turnbull said that as a market China produces a huge amount of scepticism.
“Cynicism and that is an inevitable part of the debate of a country which is facing up to big challenges,” told Morningstar. “I think people will continue to predict the death of China every single year, and I think every single year, they will be frustrated, and I think every single year that will give the patient long-term investor decent entry points.”
However it is not just the Chinese stock market that Lee is sceptical of. In December 2006, Lee gave an investor presentation with a slide entitled “Still More Signs of Market Irrationality Worrying Us”. Shortly afterwards there was a global recession and stock markets across the world began to tumble. In that slide he identified seven key indicators of market irrationality – five of which he says are now visible in the global markets.
“The disconnect between the geo-political risks around and the lack of volatility in stock markets worries me for one,” he said.
“With the exception of Japan all indices are higher now than they were in 2007 – but fundamentals are nowhere near as positive. Considering the backdrop markets should be lower. Add to that irrational bond yields – US government bonds should not be paying the same as much riskier Spanish bond yields and it makes me nervous. I am investing cautiously for a global market correction.”
