China's Stock Market: A Balance Sheet View

| About: VanEck Vectors (PEK)
This article is now exclusive for PRO subscribers.

The results of A-share listed companies in China often provide an interesting vantage point from which to view the Chinese economy. A-shares have rallied recently, but underlying fundamentals reveal potential problems.

Overall, aggregate fiscal 2012 revenues grew by 9% for A-share listed companies, but total profit growth was essentially zero, and slightly negative when compared with the adjusted 2011 numbers. Profit declines were most severe for Chinext listed small companies. This trend reversed slightly in the first quarter of 2013. However, more troubling trends are apparent from balance sheet data reported in the media.

As the slowing global economy influenced exports, ending inventory balances for A-share companies increased 17% in 2012 compared with 2011. According to a chart featured in the China Securities Journal, average days of sales in inventory for Chinese listed companies rose from 75 in fiscal 2008 to 107 in 2012. Real estate companies in particular experienced a significant increase in backlogs of unsold units, in spite of rising profits. Large increases in inventory often mean production is not serving market needs, and the value of inventories will eventually need to be written down. Acceptable levels vary between industries, but the aggregate trend clearly indicates that there are pockets of trouble in Chinese industry.

Troubling trends have also shown up in receivables, especially in the machinery industry. Zoomlion(000157), a construction company similar to Caterpillar (NYSE:CAT), reported a drop in profits of 9%, while its ending balance of accounts receivable increased 62% year over year. Zoomlion's profits dropped further in Q1 of 2013, and it would have reported a loss without government subsidies. Sany Heavy Industry(600031) saw its profit drop by 34% in 2012, while its accounts receivable increased 32.5%. This trend continued into Q1 2013.

Another extreme example is the Sinovel Wind Group(601558), a wind turbine manufacturer that reported a loss of over 583 million RMB in 2012. It also made adjustments to its accounts receivables, reducing the allowance for bad debts. The adjustments reduced its loss by 554 million RMB. It is extremely unlikely that management's estimate of the allowance for bad debts is justified when deteriorating industry conditions are considered. If anything, allowance for doubtful accounts should have been increased, as more write downs will likely be necessary.

The financial sector accounts for more than half of all A-share company profits. The major banks are still quite profitable, although the growth in profit has slowed slightly. Of greater concern is asset quality, which has continued to decline this year. Non performing loans seem small compared to assets, at barely over 1%, however they do represent about half of the bank's overall net incomes. Overdue loans have been increasing as well. At Bank of Communications, overdue loans rose by 12% in Q1 of 2013. The current provisions for bad loans likely represent a best case scenario. Chinese banks originally listed at 2.5-3 times book value (extremely high for banks), but now trade at just slighty over book value. Yet that book value is likely inflated by a failure to recognize bad loans.

Of course, China's stock market is driven primarily by liquidity and policy, and A-share companies are still majority owned and controlled by the government. In a state controlled economy, share prices can diverge from economic reality for a longer period of time. However, unproductive debt, even if domestically financed, still indicates a destruction of wealth, and a leads to a drag on growth even in the best case scenario. Remember, Japan's debt was and still is mostly domestically held.

To quote Michael Pettis: "Excess debt doesn't pay for itself, and if you cannot identify who is paying, you haven't resolved the problem." Even though the debt is domestically held, it still represents a misallocation of capital that hinders growth. China experienced a bad debt problem in the late 1990s, but it was able to solve it by shifting the burden to the household sector (that's why bank deposit rates are artificially low). However, given how low consumption now is relative to the size of the economy, it is questionable whether the Chinese government has adequate leeway to shift greater burden onto the household sector without upsetting social harmony.

China's GDP has become increasingly credit intensive: more and more debt is being used for each incremental increase in GDP. A large amount of new credit is being used to roll over bad debts, implying that the credit growth is being increasingly driven by what Minsky referred to as "Ponzi Units": entities that are unable to pay back interest or principal from operating cash flows. The Chinese government has the option to "extend and pretend"-- but in that case, a lost decade in which growth grinds to a halt is a likely outcome.

Exposure to China A shares is available to U.S. investors through the Market Vectors China ETF (NYSEARCA:PEK), which mimics the CSI 300 Index through swaps, and the Morgan Stanley A Share Fund (NYSE:CAF), which invests directly in Chinese stocks through the QFII program. As QFII is liberalized, it's possible more opportunities for U.S. investors will open up. Investors considering potential investment into A-shares, or evaluating the influence of China on their investments should be careful to factor the balance sheet issues of major Chinese companies into their analysis.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.