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P/E Multiples: China vs. US Valuations

China based US public companies trade at fraction of the multiples that their US peers receive in the market.  Our dinosaur friends will tell you of the risk associated with these companies and will give you all the reasons why these companies, expanding from their entrepreneurial state to midsized growth companies, should be trading at significant discounts to their US peers.  The question we ask is: Are these the same people that said that typewriters work better than computers, the internet is a fad and the US will always dominate the manufacturing industry?

We all know the risk of investing in businesses that are making a transition from entrepreneurial to established enterprises, but are these risks unique to China?  ABSOLUTELY NOT - in fact we will illustrate below how Chinese businesses currently have a leg up on their US counterparts.  

Let’s start with the topic du jour:

Financial Controls:

As businesses become more complex, dollar figures expand and checks and balances are tested we must ensure that we properly evaluate these issues within their proper context.  Before we make large, unbalanced and generalized comments about the Chinese growth sector (such as the poorly written Barron’s article - “Beware This Chinese Export” - and the unoriginal and uninspiring follow-up article by Alfred Little - “12 Signs and 158 Reasons Investors Should Avoid Chinese RTO Stocks” - clearly attempt to do) it is import that we analyze this sector from a global and rationale perspective.  The problem with the aforementioned articles is that they make large and exaggerated generalizations about Chinese growth stocks without appropriately placing their analysis within the suitable perspective. The best example of this exaggeration can be seen in their attack on the auditors of these companies.  They claim that the auditors of these Chinese small cap companies lack credibility because they are not currently one of the “Big 4”.  However we would like to put this attack in proper perspective and ask everyone reading this article to conduct their own research and find a US micro cap, small cap or mid cap company that has a “Big 4” auditor or even a recognizable auditor for that matter.  Similarly, Sarbanes–Oxley is a regulation that even the regulators understand takes time to implement for both US and Chinese business, hence their continual extension of such compliance for small businesses domestic and abroad.  This being said many, Chinese companies appear to be adopting these policies and regulations much faster than their US counterparts as they understand they will soon break the requirement threshold and are taking the necessary steps to meet such obligations.

Winner: China

Loser: The Uninformed Investor

Financing:

Chinese based companies are trading at multiples, and raising capital, at a discounted multiple to their US peers.    However, we once again ask investors to avoid the generalization and misconceptions created within the industry and place each investment opportunity into perspective.  For example, when raising capital, we find it prudent to ask the simple question of “why”?  Once again our due diligence has shown us that those companies raising capital to expand their operations, acquire lucrative acquisition targets and create working capital to capitalize on their current growth (as we are seeing in China) is a better situation than raising capital simply to pay debt and functionally “stay alive” (as we are seeing in US small caps). In essence, Chinese small caps are financing growth whereby most US small caps are financing survival.  As the market develops, and the market sophistication of Chinese management teams expands, so will the multiples they receive. Soon they will realize they don’t need to raise $15 to $20 million prematurely just because the US investment banks are pushing it down their throat.  Upon this realization, we believe dilution will be minimized and valuations will rise as a whole. 

Winner: China

Loser: The Uninformed Investor

Market Exposure:

The base of investors investing in US listed Chinese companies until recently was quite small, mostly consisting of US and global hedge fund financiers.  Compounding this issue has been the large number of Chinese businesses going public in the US and the large number of companies listing on a national exchange (NASDAQ or NYSE ARCA (formerly AMEX)).  The key objective for Chinese based companies to expand their market exposure is to attract larger, longer term oriented capital bases. Recently this has begun to transpire as mutual funds, insurance companies, trust companies and larger asset managers have begun to enter the space as they are seeking a greater return on their investment through the China’s growth and profitable expansion.  Given the size of capital these firms control it will take very little movement for them to take the slack out of the market and, over time, will drive multiples and reduce the disparity between US and Chinese based businesses.

Winner: US (at the moment)

Loser:  The Uniformed Investor

We believe that the Chinese based businesses that utilize this time to expand their financial controls, continually grow their business and minimize the use of unneeded dilution will be rewarded handsomely in the future and will ultimately be the poster children for the industry as a whole.