Chinese Large Caps Not Out Of The Woods

| About: iShares China (FXI)

Summary

Shanghai Composite and large-cap index Xinhua 25 have stabilized after the crude carnage and Yuan turmoil early 2016 but remains down and underperforming S&P 500 substantially.

China’s continued growth deceleration, with the 6.5% target to be missed next year, points to further underperformance in Chinese stocks.

Valuation multiples in FXI to remain low on declining return on equity since 2011 and weak earnings outlook.

As an eventful 2016 draws to a close, it feels like a long time ago but recall the year started off with the crude oil carnage and Yuan turmoil, triggering a sharp global market sell-off, particularly in the Chinese stock market which had still been reeling from the 2015 bubble burst. Following the 30%-plus waterfall plunge from above 5000, the Shanghai Composite plummeted another 24% to begin the year before gradually recouping losses throughout the year, though remains down nearly 10% YTD. The 2015-2016 pre and post bubble burst price action in the Shanghai Composite has often been compared to the 2000-2001 Nasdaq crash, however the Chinese market has largely diverged from the analog this year.

Pre and Post Bubble Burst - Shanghai Composite vs. Nasdaq Composite

That being said, the Shanghai Composite and Xinhua 25 large-cap index (NYSEARCA:FXI) underperformed U.S markets substantially, -20% and -12% vs. S&P 500 (NYSEARCA:SPY) respectively, resuming the long-term trend of underperformance since 2009. We observed that aside from the anomaly in 2015, the relative performance between Chinese and U.S. markets has been moving as a function of the spread between China and U.S. GDP growth, which has continued to tighten largely due to ongoing growth deceleration in China.

Shanghai Composite / SPX Ratio vs. China - US GDP YoY Growth Spread

FXI / SPY vs China - US GDP YoY Growth

(Source: WorldBank, WingCapital Investments)

With the 6.5% growth target to be abandoned per Bloomberg, and the projected pick-up in economic growth in the U.S., the spread looks set to tighten further. Assuming a 6% and 2.5% GDP growth in China and U.S. respectively in 2017, the spread would be the tightest in modern history, a signal of further underperformance in Chinese stocks relative to U.S. in the year ahead.

Year

China GDP YoY %

U.S. GDP YoY %

Diff

FXI/SPY

SSEC/SPX

2008

9.65

-0.29

9.95

0.316

2.016

2009

9.40

-2.78

12.18

0.368

2.939

2010

10.64

2.53

8.10

0.331

2.233

2011

9.54

1.60

7.93

0.268

1.749

2012

7.86

2.22

5.63

0.275

1.591

2013

7.76

1.68

6.08

0.204

1.145

2014

7.30

2.37

4.93

0.200

1.571

2015

6.91

2.60

4.32

0.172

1.732

2016E

6.7

1.7

5.00

0.155

1.380

2017E

6.0

2.5

3.50

?

?

(Source: WorldBank, WingCapital Investments)

The earnings picture does not look pretty as well. Looking into the top 10 holdings of FXI, we witnessed that the weighted average return on equity has been on a steep decline since the peak in 2011, around the same time China's growth began to decelerate. The down trend looks set to continue with slowing China GDP growth.

China GDP YoY Growth vs. Weighted ROE on Top 10 Holdings of FXI

(Source: World Bank, Yahoo Finance)

With the exception of Ping An Insurance, the top 10 holdings' return on equity have broadly declined

Holding

% Weight

2011 ROE

2016 ROE

CHINA CONST BK

9.00%

22.49%

15.63%

TENCENT HLDGS LTD

8.50%

44.29%

28.55%

CHINA MOBILE LTD

7.67%

19.88%

12.11%

IND & COM BK CHINA

6.25%

23.62%

15.20%

BANK OF CHINA LTD

5.06%

18.22%

13.08%

PING AN INSURANCE

4.70%

13.08%

17.73%

CHINA LIFE INSURANE

4.19%

9.25%

4.63%

CNOOC LTD

4.08%

29.21%

-0.54%

CHINA PETROLEUM

3.73%

16.23%

5.17%

PETROCHINA CO

3.21%

13.08%

0.57%

Weighted Average

56.39%

22.9%

13.5%

(Source: Yahoo Finance, GuruFocus)

Hence, although the valuation multiples in FXI look cheap, with the weighted average P/E and P/B at 9.76 and 1.11, weak return on equity and earnings growth are justifying the low multiples in our opinion. On the latter, according to YCharts, FXI's one-year and five-year earnings growth are forecasted at 1.6% and 6.5%, compared with SPY's 5.5% and 8.6%, respectively. In addition, the FXI has a heavy concentration in Financial Services (49%), which has been hammered by soaring bad loans and falling net interest margins. Per WSJ,

Third quarter profit for major lenders reporting results this week was largely unchanged from a year earlier. A battery of policy support hasn't offset the effects of a surge in bad loans or boosted corporate lending as many firms already sag under heavy debt.

Meanwhile, although industrial profits rose 14.5% in November from a year ago, it may not be sustainable as the increase was largely fueled by rising commodity prices and a buoyant real estate market. To quote from FT,

China's statistics bureau said on Tuesday, the second-fastest monthly growth since June 2014. But the agency cautioned that growth was "overly reliant" on a price rebound in oil refining, steel and other raw materials.

Overall, we believe the Chinese market will continue to underperform the U.S. in 2017 given the murky economic and earnings outlook. Despite the cheap valuation multiples on the surface, the FXI is not a buy here due to declining return on equity and weak earnings growth. Not to mention the political uncertainty when the new Trump administration comes onboard, with President-elect Trump to announce China as a currency manipulator on his first day at the White House. One thing for certain is that it will be another interesting year ahead. Have a Happy New Year.

Disclosure: I am/we are long SPY.

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.

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