You Don't Need a CFA to Value Chinese Equities
(Bloomberg Opinion) -- What we’ve got here is a failure to communicate, as Paul Newman observed just before being shot in Cool Hand Luke. Chinese and foreign investors appear to have an acute difference of opinion over how the government’s shifting of the regulatory goalposts has affected equity valuations. A gauge of U.S.-traded Chinese stocks had fallen about 43% from its February high as of Friday afternoon, while the MSCI China Index used as a benchmark by many global investors had lost 27%. On the same day, the Shanghai Composite Index surpassed its February peak.
Cathie Wood of Ark Investment Management is among those who have sold China tech stocks, warning of a “valuation reset.” Wood told an audience of institutional asset managers that her fund had “dramatically” reduced its positioning in the country and had swapped some holdings into companies that were courting government favor by supporting its “common prosperity” campaign, the Financial Times reported last week. Legendary trader George Soros, meanwhile, criticized BlackRock Inc. for investing in China, writing in a Wall Street Journal op-ed that it was a “tragic mistake” and likely to lose money. New York-based BlackRock and other investors such as veteran emerging markets fund manager Mark Mobius have pushed back against Soros. (Ark’s Wood has also said she is optimistic about China in the long run.)
In a sense, the dichotomy in returns isn’t so surprising. Indexes have underperformed to the extent that they are weighted toward the internet sector, and the technology giants that have borne the brunt of Beijing’s regulatory onslaught aren’t listed in China. Alibaba Group Holding Ltd., the first casualty when officials halted the initial public offering of its Ant Group unit last November, is traded in New York and Hong Kong. Tencent Holdings Ltd., a $600 billion colossus confronting tighter restrictions on its gaming business, is listed in Hong Kong. The Shanghai Composite, by contrast, is dominated by state-owned businesses such as Industrial & Commercial Bank of China Ltd. and PetroChina Co. that aren’t in the Communist Party’s immediate cross hairs.
Even so, a near-50% gap over little more than half a year points to a fundamental conflict over how to price-in the emergence of a more activist government that’s intent on addressing inequality and what it perceives as socially harmful trends, such as excessive video-game playing, wealth-draining extracurricular education and effeminate pop stars. At root, the question is whether China is making incremental changes to move toward a more level playing field and a fairer society, or is reverting to hardline socialism and perhaps even spiraling down toward another Cultural Revolution.
Such risks are hard to quantify, so it’s helpful to have the man who wrote the book on equity valuation weigh in. In a blog post on Sept. 1, New York University finance professor Aswath Damodaran provided his own assessment of the China tech crackdown and how it has affected valuations of four companies: Tencent, Alibaba, JD.com Inc. and Didi Global Inc. He concludes that all four are undervalued.
Damodaran doesn’t have quite the market-moving cachet of a Warren Buffett or a Cathie Wood, but is quietly influential. Thousands of investment professionals are familiar with his valuation techniques, having studied them for the CFA Institute’s Chartered Financial Analyst program. The advantage of Damodaran over more storied names willing to talk about their investments is that he shows his work, providing spreadsheets of his discounted cash flow models that enable the curious to see how the sausage is made and how palatable the inputs are.
Damodaran considers three scenarios for the companies under the changed environment, with the government acting as a benefactor (the role it played until recently), as a net negative (his central case) and as an adversary, adjusting his estimates for revenue growth and profit margins for each. Some might quibble with the numbers here and there. With the government as an adversary, revenue for all four companies is still seen growing by 10% to 20%. The obvious objection is that an administration with the autocratic power of the Communist Party can shut down a company — or, for that matter, a whole industry — overnight if it so decides. So why not 0%, or minus 50%?
Never mind. What’s striking is that Damodaran, while disclaiming any specialist knowledge of China and simply applying the reasonable constraints of valuation logic, arrives at a view that is closer to that of the country’s domestic stockholders and less pessimistic than the bulk of his fellow overseas investors.
Just perhaps, a little knowledge has been a dangerous thing for some foreign investors perturbed by China’s shift in direction. The regulatory announcements emanating from Beijing in the past 10 months or so have been unpredictable and draconian, and the accompanying rhetoric has sometimes been alarming. It may be that local investors used to the way the Communist Party talks have been more willing to look through the noise and to trust that pragmatism will prevail, as it has for most of the past 40 years. Then again, those living in the pot may not be best placed to judge when the water starts to heat up. The conclusive truth of this communication breakdown will only become clear in time.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Matthew Brooker is a columnist and editor with Bloomberg Opinion. He previously was a columnist, editor and bureau chief for Bloomberg News. Before joining Bloomberg, he worked for the South China Morning Post. He is a CFA charterholder.
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