China Small Caps' Vanishing Profit Growth Adds to Bear Case

(Bloomberg) -- Sky-high valuations are getting harder to justify for Chinese small caps as their earnings growth disappears in the face of a government deleveraging campaign.

Combined profits of firms on the ChiNext gauge may have increased 5.3 percent in 2017, according to Bloomberg calculations based on 99 companies’ guidance and preliminary earnings. That compares with 51 percent for all 100 members in 2016.

China’s small caps have largely fallen out of favor with investors since the bursting of the 2015 equity bubble that valued the ChiNext at more than 130 times earnings at its peak. Even after sinking to the lowest level in three years last week, the Shenzhen-based measure is more than twice as expensive as the larger cap CSI 300 Index on a price-earnings basis. It was down 0.1 percent as of 2:23 p.m. Tuesday, giving up an earlier gain of 1.3 percent, while the CSI 300 Index was up 1.1 percent.

“With earnings growth slowing and possibly deteriorating further, no one would dare to buy ChiNext stocks even if valuations come down, ” said Ken Chen, a Shanghai-based strategist with KGI Securities Co.

China Small Caps' Vanishing Profit Growth Adds to Bear Case

Funding costs have risen for smaller companies in China as policy makers push ahead with efforts to cut risk in the financial sector. That’s limited the ability of firms to boost their earnings through debt-fueled mergers and acquisitions. According to China Merchants Securities Co. in a Jan. 31 note, such aggressive takeovers accounted for half the increase in small- and medium-cap earnings in 2015 and 2016.

Companies are now suffering the hangover from those deals.

Many failed to conduct thorough due diligence on targets and booked large amounts of goodwill on their balance sheets after paying high premiums on deals, said Dai Ming, Shanghai-based fund manager with Hengsheng Asset Management Co. If the acquired companies fail to meet earnings promises, buyers need to set aside provisions for goodwill impairment, which eats into profits.

“It’s the sequel of the massive dealmaking,” Dai said. “The target firms may have overdrawn their resources to fulfill earnings promises in the first few years and now growth momentum starts to wane.”

While a rally in large-cap companies ended this month, their prospects look stronger as the economy maintains growth and capacity cuts boost product prices. The combined profits of 147 firms on CSI 300 likely jumped almost 21 percent in 2017, Bloomberg calculations based on company guidance and preliminary results show. That compares with 5.8 percent for all members a year earlier.

Large companies are helped by their earnings fundamentals and authorities’ guidance toward value investing, according to KGI’s Chen. Small caps will continue to underperform, he said.

“If everyone is buying blue chips and you go for the ChiNext, you’d be the only one swimming naked,” Chen said.

©2018 Bloomberg L.P.