Small cap stocks in China’s Shenzhen market in bubble territory, risking crash
“There are a lot of worries as to what happens to the China and Hong Kong markets, in the event of a repeat of the 2007 bubble and whether it will end in tears again” - Credit Suisse analyst Vincent Chan
Small cap stocks in Hong Kong and in mainland China are in a perilous bubble, making them vulnerable to a sharp correction that would put punters in a hole at a time when the country is struggling with huge debts and a softening economy.
“There are a lot of worries as to what happens to the China and Hong Kong markets, in the event of a repeat of the 2007 bubble and whether it will end in tears again,” Credit Suisse analyst Vincent Chan said in a report.
“The bad news is that P/Es (price-earnings ratio) of small caps in China, represented by the Shenzhen SME (small and medium enterprise) and ChiNext market, are at bubble valuations. At some point, there will be a massive correction of these stocks. Avoid this space!!!” warned Chan.
The Shenzhen stock market has more small-cap stocks than the Shanghai stock market, which is populated by large state-owned enterprises (SOEs).
Shenzhen remains overvalued despite the sell-off last Thursday when it slid 5.5 per cent.
On the simple price/earnings ratio (P/E) metric used by most analysts, the average P/E of Shenzhen A-shares has surged to 61.33 times on May 28 from 39.86 times on February 28. The average P/E of the GEM (Growth Enterprise Market) has grown nearly eightfold to 88.32 times on May 28 from 11.96 times three months ago on February 28.
In comparison, the average P/E of the main board of the Hong Kong Stock Exchange and Shanghai A-shares were at 12.42 times and 21.95 times on May 28 respectively.
Chan pointed out that in December 2007 during the last bubble, the P/E of the Hang Seng Index and the Shanghai Composite Index were at 21.1 times and 59.2 times respectively.
Most analysts would prefer a P/E of 15 to 20 and consider the valuation of stocks stretched and due for a pullback if the figures run too high.
But a Bank of America Merrill Lynch (BOAML) report argued that with China’s huge and rising corporate debt, the use of P/E is “meaningless” and a more appropriate measure of valuation is the Enterprise Value (EV) to Earnings before interest, tax, depreciation and amortization (EBITDA).
EV measures the value of a company based not only on its market capitalisation but also debt, minority interest and preferred shares.
China’s corporate debt has nearly tripled to US$12.5 trillion from US$3.4 trillion in 2007 and now accounts for 125 per cent of China’s GDP, up from 72 per cent in 2007, BOAML pointed out.
The median EV/EBITDA ratio of China’s A-shares is 27.0, the highest in the world compared to 10.6 for Hong Kong and 12.3 for the US, BOAML said. The median EV/EBITDA ratio of A-shares is 4.6 times China’s GDP growth, whereas that number was 1.4 times at the peak of the last bull market in October 2007, BOAML noted.
“Chinese A-share valuations have come unhinged from monetary conditions, nominal earnings and economic growth,” Merrill said. “Investors in A-share equities are being asked to pay the world’s highest EV/EBITDA multiples among the world’s lowest debt-adjusted ROEs (return on equity).”
