Goldman's China Portfolio: Professional Investing or Day Trading Rag?

Sometimes "professional" investment research resembles little more than a day trader rag with nicer charts and fancier wording to make the reader feel less guilty and more professional about the kind of "investing" he or she is actually performing. Thus we point to Goldman's (GS) recent China "Portfolio Strategy" dated July 31st where they tell us to basically keep buying the Chinese market based on government support for the economy and a "favorable liquidity setup". We're told to buy on dips, "stay engaged" (i.e. keep generating commissions), and trade earnings surprises. Is this professional investing or what your college roommate was doing during the dotcom bubble? It's hard to tell the difference.

Market view: Stay invested; buy on dips for new money A-share market gained 12.4% in July despite a 5.3% correction, which was provoked by concerns regarding credit tightening, on July 29. We maintain our positive market view on A shares and think the government’s pro-growth policy stance, which should ultimately lead to macro/earnings recovery and a favorable liquidity setup, will continue to bode well for equities.That said, we see price volatility nudging higher as uncertainties revolving around interim earnings and the government’s monetary policy stance intersect with an above-mid-cycle multiple (24x). We would stay engaged in the market and look for opportunities to accumulate positions on dips.

Strategies: Domestic demand exposure; Trade earnings surprises. We recommend investors to focus on the following themes to gain exposure to the A-share market: (1) Laggards with valuation buffers and reasonable EPS growth; (2) Pro-cyclical domestic demand, which includes banks, insurance, property, and selected consumer and materials names; (3) Stocks that are potentially subject to positive earnings surprises.

That's the front page: trust the government to support the market, trust dumber investors to follow you (liquidity) and try to make little earnings trades hoping for pops. Oh wait. What about valuations? You know, what the things we buy might actually be worth?

Valuations: Above mid-cycle, but may persist CSI300 is now trading at around 23.9x I/B/E/S consensus P/E and 3.2X P/B on a 12-month forward basis against an average of 18.9x and 2.0x since April 2005, respectively (see Exhibits 1 and 2). On the basis that FY09 EPS growth for the aggregate market could be lower than the 15% that I/B/E/S consensus is currently forecasting, the forward P/E for CSI300 would be even higher at around 26.6x using our FY09 EPS growth assumption of - 5%. July 31, 2009.

So valuations are sky high and earnings estimates might be missed. But we should hang on, because high valuations may persist. That's our upside investment case. High valuations may persist... and actually need to go higher or have upside earnings surprises to really give us upside on stock prices since they are already stretched as it is. Also, note that they compare recent valuation multiples to the average since... only 2005.. which was still a pretty bullish period for Chinese equities. So valuations are stretched even above what we saw during a pretty bullish time for China, but we should just have confidence in the government and liquidity to keep pushing things higher. This is what we are made to believe is "professional investing" rather than a gambler's punting.

China: Portfolio Strategy: China A-share Stance-at-a-Glance Goldman Sachs Global Economics, Commodities and Strategy Research 4 Resembling the market situation in 2007, the A-share market seems not primarily to be driven by market fundamentals, as ample liquidity and positive investor sentiment appear to be in the driver’s seat at the moment.

So simple translation: buy a market without respect for fundamentals. You could write it much easier: "Blind buying seems to be in the driver's seat at the moment. As professional investors we recommend you sit shotgun with these guys and just hope to jump out before they hit a tree." Now think of your parents' retirement money which they put into the China/Asia Fund by simply checking a box at work, thinking it would be professionally managed. Those funds, with their money, are some of the clients of this research, some of which will surely be trading as prescribed while their companies, and Goldman, back in the US, tout the rigorous analysis and principles they use when performing investment research. Hogwash.

While we note that a high valuation alone seldom derails a market uptrend, we caution investors that valuations and expected returns are negatively correlated.

Thanks. We are given a brief warning in the piece to make it feel more prudent, yet it is a warning which oddly conflicts with the logic of the entire piece and begs substantial further investigation because of this. "Oh by the way, usually the returns you should expect are negatively correlated to high valuations, but we think you should expect high returns from high valuations." Don't think too hard about that one. Just make a trade.

We reiterate our view that the maximum justifiable forward P/E for A shares should be around 25x, which is equivalent to: (a) discounting future earnings at a cost of equity of 8.5% (3.5% ERP + 5% RFR); and, (b) above one standard deviation above average forward P/E since April 2005. That said, we do not see risk of price multiples significantly contracting from here given the still-favorable liquidity conditions in the domestic system.

So to add insult to injury, we are near Goldman's maximum justifiable valuation, but we should be buying more? I mean, what's the upside left that has any fundamental basis? There isn't much, if any, we're just being told to ride the liquidity rocket by this piece and then given a lot of charts and financial terminology to make us feel it's about something more than that. But what's the downside risk in relation to the flimsy upside scenario? It's enormous. Just imagine lower than expected earnings plus a contraction in earnings multiples even to recent averages (at 19x on their numbers going back to only 2005, which could still be too bullish in a downside scenario) and you could take the market down as much as 50%.

I'm sorry, this isn't investment research. This is a piece of writing to get people, professionals at large funds, to punt China stocks pure and simple. You could take away the Goldman name, simplify the wording, and you'd have a daytrader rag. The downside risks are enormous should valuations simply mean-revert, due to earnings disappointment or some kind of stall in the flow of China's rampant liquidity. And the upside case is so flimsy and without fundamental basis, you'd think a compulsive gambler came up with it. Am I saying this kind of piece is rare? Nope, sadly, see it all the time. But this one pushed me over the edge to make a post.

(Readers will have to hunt down the piece on their own. July 31st, Goldman's "China A-Share Stance-at-a-Glance", by Thomas Deng. Part of me wants to apologize to Mr. Deng whom I am sure is under substantial pressure "to perform" even if it means chasing a short term punter rally.)

Comments

[Consider_this:]

The market can remain irrational a whole lot longer than you can remain solvent or patient.

That is the key key mantra.

I do not doubt China is blowing a bubble; I also do not doubt that some of the stocks are overvalued. However, consider this with the big picture, and you tell me where to put your money:

USA is coming off the biggest bubble scheme in history. A never before seen perfect storm collision of: Credit, Housing, Debt bubble and even stock are bubbling orders of magnitude bigger than what China offers.

From a realistic point of view, if you're trading assets/monetary credits from a massively bubbled economy; to a somewhat bubbled economy; you're actually doing risk reduction.

Due to global savings glut, there's really no "non-bubbled" places of the 1980's kind left in the world anymore, this even includes Oil and Glod.

Thus, you have to view our current market in perspective. GS is more right than wrong, that China's stock bubble is going to take a while to run to exhaustion -- far longer than how other bubbles is going to unwind.

The big bubble you should worry about is UST and the real RE market that's currently being covered up through a series of Mark to Model, TARP, Not going to foreclosure, Not relisting REO, Not recognizing security paper losses problem.

China's tiny stock market pales in comparision.

Aug 04 11:27 AM

[James Lewis:]

With all due respect Vincent, Goldman have made around $3 billion in China. And have been at the forefront of the pulse with China over the last 4 years at least.

Also if the PE is around 23.9 (I though it was a lot higher), then the market is still not trading at stupid levels. There is a high proportion of stocks that can only be considered growth stocks. And based on the inflation emanting from loose fiscal policy and QE, this pe can move down purely from the devaluing of the Yuan domestically due to inflation.

I think the market is entering its topping phase. I get the sense the smart money is selling out to the weak hands. Having watched price action I expect to move a little higher as this distribution phase pans out. And then we sell off. However this by no means marks the cyclical top. If China carries on and mitigates the growing risks by reform, the market will top 10 000 in the next 5-10 years. Of course we all know there are a lot of risks. But do not assume they will not reformed because doing so blocks out potentially the best trading opportunity of this decade.

Aug 04 12:59 PM

[Vincent Fer...:]

Consider: You'd think people would have learned that chasing a bubble isn't a robust investment strategy, given how recently so many got creamed doing so. The point of the piece is that bubble chasing is no better than a retail trader, and that you should expect more from "professional research". We all know that bubbles can run for quite some time, but a truly disciplined investor who has a knowledge of the history of markets isn't chasing them, even if for a few years others are making money, out of knowing too well the risks involved and that it can be a fool's game trying to get out before everyone else. Sorry, but I expect more from research if it's supposedly professional.

Aug 04 01:04 PM

[Vincent Fer...:]

Freya: that's not true I know of pro's who have done well or at least ok through the crisis. You can be long/short, and you can also reduce your long exposure without going to the extreme of 100% cash. Note US treasuries rallied like crazy at one point during the crisis.

James: I am not doubting Goldman's ability to make money. What I am doubting is the ability for their latest China piece to provide a prudent way for their brokerage clients to make money. Let's look at what they say, not just stop at "Well they're Goldman, so it must be pretty good advice" The point of my article is that we should have some sort of value underpinning our investment decisions, especially if we espouse them to be rigorous and disciplined, and that Goldman's latest China justification is pretty similar to your average retail trader's thinking. Chinese shares are clearly stretched, note the market drops 5% on even the slightest inclination of the Chinese government reducing liquidity.

I'd be wary of thinking you can feel where the cycle is going without the support of valuation in case you are wrong. And there is no need to feel rushed to invest now. Buying China now is far from the trading opportunity of the decade. There will be far safer times to invest in China. There are also other ways to invest with exposure to China's growth, in other markets. Whatever upside one envisions based on further stretching of already high valuations and expectations, the downside risk is massive right now, risk-reward is far worse than it has been in awhile, and thus the investment case (not the punting case) is pretty weak. FYI I just found support from Andy Xie a long time China watcher. You can find it at researchreloaded.com/c... In either case, I appreciate your feedback.

Aug 04 03:20 PM

[Alphameister:]

Keep writing about that China bubble so my portfolio of Chinese stocks trading at 3 to 9 times rising earnings can continue to climb the Great Wall of Worry. That "bubble" seems destined to grow a lot larger before it breaks (though I'm hedged now for the short term).

Aug 05 01:14 PM

[Vincent Fer...:]

You seem to have found some pretty cheap stock picks, unless they are cyclicals. I'm saying it's pretty dangerous to buy "the market", and that Goldman's piece is far from "investment" material. Not saying that there might not be a good stock pick here or there. Hope the picks work for you.

Aug 05 01:35 PM

[James Lewis:]

Hello Vincent,

I understand your views on The Goldman Piece, short term like I said I am expecting the 'smart money' to be distributing to the small retail investors. Which has bearish short term (maybe medium term) consequences.

However who is the target audience for the goldman piece. As you know retail investors outisde China are not able to buy into domestic markets in China. Also domestic retail investors in China don't follow foreign investment bank research that closely. This suggests that the main parties buying Goldmans research to trade is larger QFII investor. These larger institiutions do not have longer term objectives, really they are just funneling hot speculative investment flows into China. Doing so in order to take advantage of RMB revaluing and profit from the governments objective of diverting the huge chinese household savings into a financing mechanism for the countries large strategic companies (which are controlled by the state in almost all cases). The advice given fits the profile of the hot money investors.

I understand the essence of your piece is that you feel large institutions should protect retail investors by producing responsible investment reasearch. Which is commendable on all levels. Something that we will probably never see , as the institutions know in essence if retail investors were informed. They would find it harder to swindle their money in distribution phases. (where banks etc sell to investors at the top of the market)

Aug 08 09:03 AM

[Vincent Fer...:]

Noted Mr. Lewis. I would just add that I would hope that the QFII investors were doing more than what you say. But I agree they are pretty much doing that.

Aug 09 11:24 AM