The fund house said it sees potential for a re-rating of Chinese equities in the medium-term as it expects the government to come out with deep reforms to revive the struggling sector.
“In 2015, we expect SOE reform to be bolder and more wide-ranging, including reform of a number of giant SOEs.”
This would result in bottom-up opportunities for active managers, the fund house added.
SOEs comprise 77% of the CSI 300 Index (an A-share index) and 87% of the Hang Seng China Enterprise Index (an H-share index), respectively. They make up for 72% of the market capitalisation of the MSCI China.
In the context of the Shanghai-Hong Kong Stock Connect, SOEs represent around 60% of the market capitalisation of eligible stocks for northbound (Shanghai) and 70% for southbound (Hong Kong) trading.
Poor profitability
The fund house expects a series of announcements for major SOEs and a detailed plan on the SOE sector later this year.
“Property values tend to increase after renovations. Likewise, with the central government’s strong determination to reform state-owned enterprises, this should help unlock their value, which (until recently) has been very depressed due to poor profitability.”
JP Morgan cited official data for more than 360,000 industrial enterprises, which showed SOEs still account for 38% of total industrial assets, but contribute only 22% of profits and 17% of urban employment.
“All these figures confirm that SOEs in China are still very big in terms of their importance to the economy, and the main problems today are poor governance and inefficiency.”
The reforms are likely to span key areas such as mixed ownership in SOEs, which could induce competition to break up monopolies.
Asset injection into subsidiaries to enhance productivity, improvement in corporate governance and an increase in dividend payments to state shareholders are other likely reform areas.
“[R]esistance to reform from vested interest groups is likely to be strong. Any news flow about the reform of China’s state monopolies should therefore attract investors’ attention.”
Valuations still cheap
The fund house believes SOEs are still cheap in terms of valuation despite their recent rally.
A-share SOEs are currently trading at 1.8 times the 12-month trailing price-to-book value (PBV), a 55% discount to non-SOEs, which are trading at 4 times PBV.
If banks are excluded, SOEs are still valued at 2.3x PBV, a 43% discount to non-SOEs.
“The cheap valuation of Chinese SOEs seems to imply that investors have been penalising them for their poor profitability, or lower return-on-equity (ROE).”
Many investors have the perception that the ROE of private companies has been higher than that of the SOEs.
“However, this is not necessarily an ‘apples-to-apples’ comparison. The 12- month trailing ROE of private companies is just slightly higher than that of SOEs ex-banks,” the fund house said.
