ANALYSIS-Hopes still pinned on cheap Chinese shares

LONDON, April 1 Tue Apr 2, 2013 1:17pm BST

LONDON, April 1 (Reuters) - The triumph of hope over experience. That might describe investors' continuing infatuation with Chinese stocks despite mostly meagre rewards in the past.

Though MSCI's China index is languishing 4 percent in the red this year, many fund managers are betting the stars are finally aligned for a lasting turnaround in China's equity index, the biggest in emerging markets.

A lot of cash is riding on hopes that last year's bumper 23 percent return marked an end to a multi-year loss-making run. Data from fund tracker EPFR Global shows more than $8 billion has flowed to China equity funds this year - over a third of the amount taken by emerging market funds as whole.

So why, despite years of losses, are investors so bullish?

For one, growth appears to have stabilised after hitting decade-lows last year. The Communist Party's new leaders have announced reform plans to boost domestic consumption while regulators have suspended approvals for new IPOs to curb unbridled equity issuance.

Most crucially, fund managers say, these factors are not reflected in Chinese share prices, which trade a quarter below their own past 10-year average, based on forward earnings.

"We are not jumping up and down, saying we expect huge gains this year but we do expect a steady upward move," said Jeff Chowdhry, a fund manager at F&C Investments who is "modestly overweight" Chinese shares.

"We expect a gentle improvement in economic outlook, that provides a supportive backdrop for companies to grow earnings."

But in what has become a familiar pattern, exuberance that took hold last autumn has dimmed, with the index now 8 percent off the 4-1/2-year highs of early February.

Recent earnings have disappointed, with Reuters Starmine data showing that over half the Hong Kong-listed Chinese firms that reported 2012 results by end-March had missed forecasts.

Fears of more real estate curbs - with a potential knock-on impact on steel, cement and banks - have also weighed.

China is nevertheless still fund managers' fifth largest overweight in emerging markets, Bank of America/Merrill Lynch's monthly survey finds. Net overweight positions were as high as 50 percent last month though they fell to 11 percent in March.

BITTER EXPERIENCE

Investors' continued keenness on China may seem surprising given their bitter past experience.

Having poured over $50 billion into Chinese equities since 1995, international funds have found out the hard way that booming growth is no guarantee of equity returns. Except for a brief 2003-2007 period and the end-year spurt in 2012, the MSCI China index has mostly lost money.

But Bill Maldonado, Asia-Pacific CIO for HSBC Global Asset Management, reckons the market is at a turning point as fears that have dogged it since 2008 recede, whether of an economic hard landing, leadership changes or a world growth collapse.

Evidence, according to Maldonado, will come this year via upgrades to earnings forecasts, rather than the reverse that is usually the case in China. He predicts 13-14 percent earnings growth in 2013, versus forecasts of 10-12 percent.

But shares are trading well below their past average and are much cheaper than for most other emerging markets.

"That's very supportive given the relatively high level of earnings," Maldonado said. "I can buy the Chinese market on a price-book of 1.25-1.5 but experience return-on-equity (ROE) in 2013 of 20 percent. Show me another market that will give me 20 percent ROE at that valuation."

As a multiple of forward earnings, MSCI China trades at 9.1 times compared to its past average of 12 times and the emerging markets average of 10.3 times, Thomson Reuters data shows.

"Earnings growth has been decent in the past three years but MSCI China has moved sideways. That means Chinese companies have become more and more undervalued," says Gustav Rhenman, a portfolio manager at East Capital in Stockholm.

Take two of China's biggest banks, Bank of China and Agbank. Both trade at a price-book ratio of 1 or less, well below peers in India or Russia. Versus forward earnings, BOC now trades under 6 times, from 8.6 in early 2011.

Shares in both banks are down this year after they posted their worst ever annual results. Investors point out that earnings actually grew 19 percent and 12.2 percent respectively, however. In 2011, they grew 28.5 percent and 19 percent.

STILL WAITING

The reality is that returns are still elusive.

The MSCI index is back at December 2012 lows on fears that the real estate recovery and an explosion in non-traditional lending risk further policy tightening. That could fuel a surge in bad loans at banks, in turn hitting property shares.

Given these risks and high levels of state ownership in the market, cheap valuations are justified, critics might say.

Investors counter that current share valuations effectively pay them to take that risk. And potential rewards are great, maintains veteran investor Mark Mobius, executive chairman at Franklin Templeton's emerging markets group.

Consumers in China have been benefiting from annual wage increases of 20 percent or more, Mobius notes, while the new government has made urbanisation a priority.

"It's our expectation that as disposable income increases for China's middle class, more personal assets could be funneled into savings and investments," Mobius told Reuters in an email.

He is one of many who now hope that an era of slower growth in China will mark a shift towards more steady equity returns. (Editing by Catherine Evans)