Earnings momentum has been the standout factor for outperformance of Hong Kong-listed Chinese equities compared to six other factors: size, profitablity, volatility, value, leverage and growth, said Chan, speaking at the Morningstar Institutional Conference last week.
HSBC GAM back tested earnings data from 2003 to 2016, she added.
Theoretically, one can capture outperformance by betting on companies with higher earnings expectations, in terms of six-to- twelve months forward earnings. However, the reality is that it is not an efficient way to estimate a company’s earnings, she said.
“To our surprise, for [one of the biggest] stock markets in the world, the accuracy of earnings forecasts is very low. Every year, about 60% of Chinese companies get massive earnings revisions.”
To back up her statement, she referred to a Goldman Sachs report. It said that of the companies tracked by the MSCI China Index last year, 35% of them had downward earnings revisions of 10% or more while 13% had upgrades of at least 10%.
Among the 21 sectors within the index, materials companies have had the biggest number of earnings revisions for the past three years.
“The consumption sector, such as food and beverage companies, see the second largest number of earnings revisions as top-line growth has slowed down rapidly.
“It shows how inefficient the market is and why a bottom-up approach is very important.”
Her firm uses DuPont analysis to evaluate company earnings, which she believes gives accurate estimations. The analysis breaks down the return on equity (ROE) into three parts to measure top-line growth, financial leverage and profit margins.
“[Generally] top-line growth of Chinese companies has been quite stable, while the high leverage of companies is not a secret. We don’t want to see a growing leverage ratio which will drag down a company’s ROE.
“More importantly, where the market is always wrong is the margins,” she continued. The reason is that some operations of a listed Chinese company may be sitting inside other private companies or with distributors.
“By just looking at the financial statements of listed companies, there’s no way you can get the margins accurate. We spend 60-70% of our time talking to consultants and distributors to complete [the picture].”
Using the internal analysis, she believes her firm has 70% accuracy on earnings forecasts.
Property sector equities
Chan is positive on the Chinese property sector and commodity space over the medium term.
“The four first-tier cities only account for about 5% of overall transaction volume and construction activities in China. Although they lead in pricing, they have no economic implications for China.”
Second-tier cities account for 35-40% of real estate construction activities in China, suggesting the third and fourth-tier cities are the most important part to look at, she said.
The first-tier cities have had the most severe undersupply problem over the past five years, while tier-two cities have achieved supply and demand balance.
“We waited for five years for tier-two cities to turn balanced. And it has big implications. The construction activities have turned positive last year from a very big negative drop, leading to strong commodity demand and also home price increase.”
While most investors are concerned about the third or lower-tier cities amid high inventories, Chan said the situation is improving beyond expectations.
The firm earlier estimated that it would take three years for these cities to digest all the real estate inventory, provided there was no new supply.
“To our surprise, the transaction volume in tier-three cities went up by 40%-50% year-to-date. Because of it, we only need one-and-a-half years to clear up all the inventory.”
In the long-term, however, demand is expected to shrink because of demographics. Young couples as first time home buyers are decreasing in number.
“When we focus on the age group of 20-29, the core home buyers in China, they account for 17% of the population in China at the moment. By 2025, they will account for 10%.”
She thus estimated first home demand to contract by 40% by 2025, or 20% of the overall property market transactions.
Three-year performance of HSBC GIF Chinese Equities Fund managed by Chan, versus the benchmark MSCI China Index and category average, according to FE.
