Hong Kong H-shares (in the Hong Kong China Enterprise Index) have been on a roll, but still lagging Shanghai A shares. The index is selling for 8 times earnings, one of the world’s cheapest. The key takeaway is that the the price of the index has been rising for the past year, but the P/E hasn’t. In other words, H-share prices have just kept up with higher earnings.

Compare that to the MSCI world equity index below.

The surge in the MSCI World Index is driven entirely by valuations — that is, the P/E line tracks the index price line.

That makes China H-shares the world’s biggest bargain. Of course, if you believe that China is about to blow apart politically or implode economically, there are reasons to be cautious. But there aren’t a lot of examples of political or economic implosion in countries where incomes are rising by double digits, the current account is in surplus,  the central bank holds 3 trillion dollars in reserves, and the economy is growing by “only” 7% (that is, doubling every decade).

The cheapest sector in the HSCEI remains the banks. China Construction Bank in Hong Kong is trading at a trailing P/E of 5.8 and an estimated P/E of 5.3. The issue with the banks, of course, is provisions for loan losses. These seem low compared to what we know about credit problems on their balance sheets.

Let’s assume that China Construction Bank (as a pure hypothetical example) quadruples its loan loss provisions and revises its earnings going back to 2007 to reflect this. With 4X the loan loss provisions, this is what its net earnings would look like:

In this hypothetical case, China Construction Bank would be trading at 9 times earnings, rather than 5.3 times earnings, still a lot cheaper than the Eurostoxx 600 Bank Index or the American BKX (KBW Bank Index), both trading at a forward P/E of 12.

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