2015 Anti-predictions round up: Chinese stock market - Morphic Asset Management



In July we predicted that “China shares will not finish the half below the current 3600 on the Shanghai Composite”.

Our thesis had two limbs: 1) we didn’t really believe we were in a bear market in China, but (2) even if we were, we thought we were probably due for a bear market rally.

We are still only line ball in our call, with the index today at 3655. However the price action, in the form of a very steady climb since the bottom below 3,000 in mid-August, suggests there is plenty more scope for the bull market to resume.

Partly this is because emerging markets generally seem to be bottoming out, even in the wake of last week’s interest rate hike in the US, the first in nearly a decade. As our non-executive director colleague Gerard Minack points out, macro data in emerging markets is proving, if not good, at least a little better than expected.

But in China’s case the biggest driver for the market is probably a ‘bad news is good news’ model, where further weakening in the economic outlook results in more pressure for more government spending on infrastructure and for the Peoples Bank of China to cut interest rates and turn a blind eye to capital outflows which are putting downward pressure on the Chinese Yuan, which is now down about 4% year to date.

It probably needs to fall quite a lot further to head off the recession in parts of the Chinese economy like construction and heavy industry, where growth is virtually zero, or around the levels that triggered China’s last great round of stimulus during the GFC.



Expectations of a stimulus are driving a recovery in Chinese banks, which we have avoided because we believe there is a huge risk in their balance sheets where we fear lots of bad loans are still unrecognised.

We are tentatively looking at the kind of companies that might benefit from smarter public spending initiatives like improving China’s still very dodgy water and sewage networks, such as the country’s biggest PVC and polyethylene pipe maker China Lesso, which is trading on an expected PE of about six times 2016 earnings.

It is the largest national player in a fragmented industry – in fact it is 5x larger than #2 competitor –  and controls 40% in their home region of Guangdong. It is also the only national player benefiting from further developments of Tier 3 cities. The company has been increasing profitability every year since 2011 and we think the trend is set to continue. Falling oil price means reduced input prices, while the management is exploiting the scale to automate production – and reduce labour cost by over a third!

Over the last three years, the company has made a substantial investment in capacity expansion and research and development. The investment is beginning to pay-off: our analysis suggests it sets them to grow twice as fast as the China market through 2020. In the meantime, the company is set to almost double cash flow next year and the 10% FCF yield offers a substantial margin of safety for our investment.

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