Red Bull: The Case for Chinese Stocks

07/06/2012 9:00 am EST

Focus: GLOBAL

It's pretty simple: the Middle Kingdom's stock markets look fairly cheap, write Richard Beales and Wei Gu of The Globe and Mail.

One kind of China shop may be luring the bulls. And its leadership transition may coincide with an economic boost. It is hardly risk-free, but there's a case for going long Shanghai.

China stocks are in the doldrums. The price-to-earnings ratio for Shanghai Stock Exchange A shares stood at 8.8 as of July 5, based on forward estimates of profit—not far off the lowest on record, and barely more than half the long-term average. In the sluggishly growing United States, by comparison, the equivalent P/E ratio for the S&P 500 index is about 12, against a long-term average of 15.

The Shanghai composite index, though well above its 2008 nadir, could almost triple before surpassing its admittedly frothy 2007 high.

Meanwhile, after deliberately cooling growth for a time, Beijing's policy makers on June 7 cut borrowing costs for the first time since the financial crisis. Central bankers rarely make only one such move, and there are other tools in the policy kitbag.

It's a challenge for policy makers to stoke some sectors while reining in others, like property. But so far, China can claim a decent recent track record on economic management.

Liberalization of stock ownership rules could feed demand. For example, the quota for qualified foreign investors is going up to $80 billion from $30 billion, bringing in new funds worth about 2% of the Shanghai exchange's $2.4 trillion market capitalization.

Also, Chinese provincial pension funds may eventually be allowed to buy stocks. Even 20% of their roughly 2 trillion yuan ($315 billion) of assets would represent significant new demand.

That said, domestic investors' confidence is at a low ebb. One reason is that earnings at big state-owned enterprises have been shrinking. There is also a supply overhang from as many as 700 companies waiting to float in China.

Accounting and governance concerns are a potential drag too. And Europe's ongoing troubles represent a big external economic concern.

Outweighing these worries for China optimists, however, is more than typical confidence on timing. A new president, putatively Xi Jinping, will be chosen along with other top officials later this year and inaugurated early in 2013.

The new leaders may be eager to stimulate the economy and markets. If they manage that on cue, China's stocks could start gathering steam late this year or early next.

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