China and India reveal emerging market mistakes

Tiger trap. Investors make two profound mistakes when approaching emerging markets. First of all, they are fascinated by GDP growth even though there is no evidence of a positive correlation between an expanding economy and stock market returns. Second, they assume that ratings are a reliable predictor of returns. The strong outperformance of Indian stocks relative to Chinese stocks since the 2008 financial crisis shows how misguided this approach has been.

The word “emerging” itself suggests that less developed economies with strong growth prospects can be expected to generate superior investment returns. Let’s see how that turned out. Over the past 15 years, the Chinese and Indian economies have grown rapidly. China GDP grew about 2% a year more than India, when measured in constant US dollars. In September 2009, the price-earnings multiple of the MSCI China index was 25% lower than that of the MSCI India index. However, despite starting at a lower price and experiencing faster economic growth, the Chinese stock market since 2014 has generated total annual returns of just 2.5% in dollar terms. Indian stocks have compounded four times that amount annually, according to Jefferies.

There is a relatively simple explanation for this divergence. In late 2008, the Chinese government in Beijing launched a massive stimulus to stave off the global financial crisis. He used the country’s enormous domestic savings to finance an extraordinary investment boom. Gross domestic fixed capital formation shot up from 38% to 44% of the GDP and has remained high. The investment splurge was accompanied by rapid credit growth and backed by easy money. In contrast, India had relatively low savings and investments. Between 2009 and 2020, investment fell from 34% to 27% of GDP. Indian interest rates were on average twice as high as those in China.

Economic theory postulates that the return on capital should eventually equal its cost. Indeed, China’s low cost of capital has generated meager returns. Capital has been misallocated on a large scale, as evidenced by chronic levels of overcapacity across the economy. Since the housing bubble burst in 2020, the People’s Republic has been beset by debt deflation. India did not enjoy any real estate, credit or investment boom and thus avoided the resulting hangover. Its relatively high cost of capital produced relatively high returns on investment.

This macroeconomic analysis is evident in the reports and accounts of listed Chinese and Indian companies. One indicator of whether a company is investing prudently is the ratio of new capital spending to the depreciation of past investments. Gillem Tulloch, founder of Hong Kong-based GMT Research, has examined the returns of Chinese and Indian companies that have a minimum of 10 years of data, which is equivalent to about a quarter of the companies listed on both markets. . In 2014, the average capital expenditure of Chinese public companies was 2.3 times depreciation. The ratio for their Indian counterparts was considerably lower, 1.5 times. Since then, Chinese companies have consistently outinvested their Indian counterparts.

A key component of profitability is measured by the relationship between a company’s sales and its total assets. More efficient companies have a higher level of asset turnover. Tulloch finds that this measure in India averaged about 1 times over the last decade. On the other hand, the average Chinese company reported sales relative to its assets at half that level. As a result, the return on equity (ROE) of Indian companies between 2014 and 2023 remained stable in the range of 10% to 13%, while the average ROE in China fell from 10% to 6% during the same period. , according to Tulloch.

As investment returns have lagged economic growth, Chinese companies have had to raise more capital, thereby diluting existing shareholders. The total number of stocks in the MSCI China index has increased 2.5-fold since 2014, according to CLSA. However, earnings per share have barely changed. Investors have taken notice. The valuation of the Chinese benchmark has declined from more than 2.5 times book value in 2020 to 1.3 times earlier this year. Meanwhile, the price-to-book ratio of the MSCI India index, which averaged just over 3 times over the last decade, has risen to 4.5 times.

Alex Duffy, emerging markets specialist at Marathon Asset Management,arguesthat India’s capital discipline is beginning to break down. Indian companies are currently adding new capacity in a variety of sectors, including steel, cement and power generation. Jefferies expects India’s share of investment GDP will increase from a low of 28.5% to 33% over the next three years. High stock market valuations have attracted a flood of initial public offerings. According to Jefferies, financing of private investments by banks and other financial institutions has almost doubled since 2022.

Retail investors have helped push valuations of Indian mid-cap stocks to 35 times forecast earnings, a 70% premium to their long-term average, without any discernible improvement in growth rates or underlying profitability. Duffy says.

While India’s stock market shows signs of a speculative slide, China’s capital cycle may be approaching a trough. According to Tulloch, the capital expenditure/depreciation ratio of Chinese companies has dropped to 1.5 times, in line with Indian levels. Capital raisings in the private market are down 98% since the pre-Covid-19 period, Duffy says. The securities regulator has ordered listed companies to increase their distributions to shareholders. Share buybacks now account for nearly 40% of total payments. As share buybacks increased, the number of shares outstanding began to decline, according to CLSA. In principle, a decrease in the number of shares should boost earnings per share growth.

Since Beijing unveiled a new stimulus package last week, Chinese stocks have been on the rise. The People’s Bank of China promises to provide loans to companies to buy back more shares. That’s not enough. Chinese industry needs to eliminate excess capacity, says Duffy. It is unclear whether President Xi Jinping has gotten the message. Chinese investment may have decreased as a proportion of GDP but it’s still a heady 42%. Chinese stocks may still look cheap on all valuation counts. However, until there is clear evidence of a supply-side squeeze, emerging market investors should remain cautious.

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