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 (NYSE: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.)