Chinese internet stocks returned 65% over the past year, compared with 45% for the Nasdaq 100. As we observed last week, monetary factors drove the returns on American tech stocks. Negative real yields on Treasury securities pushed investors into the most predictable equity cash flows.
The big American tech companies (Apple, Microsoft, Amazon, Google, Netflix and so forth) have monopoly positions in their markets; if they paid dividends they would be the new utilities.
Let’s reverse the question: Why should Amazon trade at a multiple to earnings roughly triple that of its closest Chinese equivalent, Alibaba? The Chinese internet retailing giant trades at a bit over 20 times predicted earnings, versus 60 times expected earnings for Amazon.
Alibaba is growing faster. Its revenues rose 370% during the past three years, versus 223% for Amazon. The two companies provide roughly the same return on equity, at slightly over 20%. Alibaba’s operating margin is about 15% versus about 5% for Amazon – but that to some extent reflects a different business model.
Still, there is nothing in the revenue, growth and profitability parameters that explains this enormous discrepancy in the price-earnings ratios for the two firms.
The forward multiples of US and Chinese banks show a similar discrepancy. JP Morgan, the largest and most profitable US bank, trades at a forward multiple of about 14 times earnings. That’s close to its historic highs – excluding the exceptional 2008-2009 crisis period. China’s best-managed large bank, judging by loan loss ratios, is China Construction Bank. It trades at less than 5 times forward earnings, close to the bottom of its historic range.
As we noted last week, earnings are priced at a much higher multiple in the United States than in China:
This is the case despite faster earnings growth in China.
Part of the explanation lies in negative real US interest rates versus positive real Chinese interest rates, as we saw above. Moreover, for most of the past decade the volatility of the Chinese stock market – as measured by the implied volatility of options on the ETF that tracks the broad MSCI China Index versus the VIX Index of S&P 500 options – was endemically higher. But the implied volatility of the two markets appears to have converged during 2020.
Volatility isn’t the only measure of risk. China’s governance is less predictable and leaves investors more susceptible to surprises.
An example is the surprise cancellation of the Ant Financial IPO in the first week of October. Beijing’s regulators had reasonable grounds to challenge Ant Financial’s use of leverage, estimated at between 40 and 60 times capital by different analysts. But the sudden decision to postpone what would have been the world’s largest-ever stock offering only days before the event rattled the market.
A decision that momentous would have been debated, parsed in the press, and signaled well in advance in a developed stock market. For three months after the event, Ant Financial founder Jack Ma remained out of public view. Finally he reappeared on January 20.
The threat of sanctions against Chinese companies also depressed stock prices. Although the American market accounted for under a tenth of the money raised by Chinese companies in initial public offerings during the last several years, the uncertainty associated with US government action against listed Chinese firms kept investors away from H-Shares, which are freely tradable by foreign investors.
With the exit of the Trump Administration and the likely softening of America’s attempt to contain China, political risks to the Chinese market should recede.
As China’s regulators learn their job better and avoid the sort of surprises that upset the market in October, investor confidence in Chinese equities should improve.
The Trump Administration had a valid point when it demanded that Chinese companies report financial data according to American accounting standards. There are at least some indications that the Chinese authorities will push companies to improve their reporting standards.
The market has learned in the last three months that the United States does not have the power to contain China’s growth, and that the Chinese authorities have acted rationally – if clumsily – to address real concerns. Neither Washington nor Beijing represents a serious threat to Chinese equity markets.
By the standard market measure of risk, namely volatility, we already have observed a convergence of risk between the US and Chinese equity markets. A reduction of economic tension between Washington, now under the Biden Administration, and Beijing should reduce risk further.
That suggests that equity market valuations should converge to some extent between the United States and China, and that Chinese equities will continue to outperform their American peers.