Quant Macro Investing

Risk Taking Disciplined

China’s 71% Small-Cap Stock Premium Signals Peak

Feb. 26 (Bloomberg)

The rally in China’s small-cap stocks that lifted valuations to a record premium above the largest companies’ shares is a signal to sell, according to three of the country’s biggest money managers.

China’s CSI 500 Index of companies with a median market value of $841 million trades at valuations 71 percent above the CSI 300 Index, up from 31 percent a year ago and near the all- time high of 77 percent in December, based on estimated price- to-earnings ratios compiled by Bloomberg yesterday. Shanghai- listed Guizhou Guihang Automotive Components Co. trades at a record 61 times profit forecasts, triple the multiple for PetroChina Co., the world’s biggest company.

“Small caps are now at the top of their valuations,” said Zhao Zifeng, who helps oversee about $10.2 billion at China International Fund Management in Shanghai. “Big caps have enough safety margin and are likely to outperform.”

Zhao and money managers at JF Asset Management and HSBC Jintrust Fund Management Co., which oversee more than $60 billion, say Chinese small-cap stocks are expensive after fourth-quarter profits trailed analyst estimates by an average 38 percent and the People’s Bank of China raised banks’ reserve requirements to slow the fastest-growing major economy.

The CSI 500 climbed 0.1 percent today to 4,634.67, while the CSI 300 fell 0.3 percent.

The valuation premium on small Chinese companies over their larger peers is wider than in any of the 10 biggest equity markets. Small-caps are valued at a discount to larger stocks in Hong Kong and India, according to data compiled by Bloomberg.

Double Brazil

China stocks surged as investors bet record-low interest rates, a $586 billion stimulus program and $1.6 trillion of state-directed lending would boost profits at the fastest- growing companies. The world’s third-largest economy expanded at a 10.7 percent annual rate in the fourth quarter, up from a revised 6.2 percent in the first three months of last year, the slowest pace in almost a decade.

Property prices climbed 9.5 percent in the year to January, according to the National Development and Reform Commission in Beijing, a rally James Chanos, the founder of New York-based hedge fund Kynikos Associates Ltd., said is a “bubble” poised to burst.

The CSI 500 trades at 29 times profit estimates after an 80 percent jump in the past year that beat the 50 percent advance in the CSI 300 index, according to Bloomberg data. The valuation is more than double the 12 times estimated earnings multiple for the MSCI India Small Cap Index and 13 times for Brazil’s Bovespa Small Cap Index. The Russell 2000 Index of U.S. companies trades at 23 times, Bloomberg data show.

Options Trading

“Big caps look like better value than small caps,” said Howard Wang, head of the Greater China team at JF Asset Management, which oversees about $50 billion. Excluding the risk of a sovereign debt crisis, “we think China big-cap equities are cheap,” Wang said.

Prices are increasing to protect against a tumble in large- cap stocks. Options profiting from a decline in the iShares FTSE/Xinhua China 25 Index Fund are trading near the biggest premium in 11 months compared with contracts that benefit from a gain, Bloomberg data show.

BNP Paribas SA’s Hong Kong-based strategist Erwin Sanft predicts small-caps will be the best-performing segment of the Chinese market this year because of faster earnings growth. Analysts expect profits for companies in the CSI 500 will rise 41 percent this year, topping the 23 percent increase for CSI 300 companies, Bloomberg data show.

Too Optimistic

Estimates for fourth-quarter small-cap profits proved too optimistic, with results reported so far from companies in the CSI 500 index trailing projections by 38 percent, according to Bloomberg data.

Earnings missed forecasts as the government took steps to restrain stock and property gains and consumer inflation. The People’s Bank of China signaled a “gradual” exit on Feb. 11 from monetary stimulus including record loans that were introduced amid the first global recession since the 1940s. The central bank raised reserve requirements 50 basis points to 16.5 percent for the biggest lenders yesterday, the second increase this year. A basis point equals 0.01 percentage point.

“There’s very limited room for small-cap stock valuations to rise further,” said Ally Wang, who helps oversee about $1.2 billion at HSBC Jintrust in Shanghai. “Earnings growth prospects have been priced in.”

Cars to Chemicals

Guizhou Guihang Automotive, which makes auto parts from radiators to air filters, posted third-quarter earnings that trailed analysts’ estimates by 53 percent, according to Bloomberg data. The company, which doubled in Shanghai trading over the past year, is scheduled to report fourth-quarter earnings on March 29, Bloomberg data show.

Xinjiang Qingsong Building Materials & Chemicals Group Co., a producer of cement and fertilizers, has rallied 11 percent since reporting fourth-quarter earnings that missed analyst forecasts by 45 percent on Feb. 5. The company, based in the Xinjiang province, is valued at 39 times earnings, compared with a monthly average of 25 times, based on Bloomberg data since 2004.

Companies in the CSI 300 Index, which have a median market value of $3 billion, have topped analysts’ forecasts for fourth- quarter earnings by an average 5.2 percent, Bloomberg data show. Guangzhou-based developer Poly Real Estate Group Co., which beat fourth-quarter projections by 29 percent, is valued at 15 times profit estimates, near the lowest level in 11 months.

“Valuations of small-caps look too stretched,” said Wu Kan, a Shanghai-based money manager at Dazhong Insurance Co., which oversees about $285 million and plans to reduce holdings of the shares. “Large caps stand a big chance of shining.”

Zhang Shidong, Michael Patterson and Allen Wan. Editors: Gavin Serkin, Stephen Kirkland

March 2, 2010 - Posted by | Case Study

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