Call it a factor reversal. Small is no longer beautiful: Shenzhen’s startup-heavy ChiNext Index has underperformed the Shanghai Beautiful 50 of large-cap stocks by more than 11 percentage points in the past month. Investors are starting to embrace firms with good dividend and earnings yields, having shunned them earlier in the year.
Behind the change of heart is diverging earnings performance within the $6.6 trillion stock market.
By now, almost all the 3,000-plus companies listed on mainland markets have announced March quarter earnings – and the report card doesn’t look bad. They posted average earnings growth of 10 percent, rebounding from a decline in 2018. Sales climbed an average of about 12 percent. China’s economy has shown signs of stabilizing, with industrial output rising at the fastest pace since 2014 and credit growth reaching almost 40 percent. Companies are growing and banks are lending again, it seems.
Dig deeper, though, and many worrying signs remain. China Inc. is as frail as a house built on sand.
Financial companies reported the best profit growth – no surprise given that China’s stock and bond markets were both on a bull run during the first quarter. Bank of China Ltd, for instance, reported its best non-interest income in at least a decade thanks to mark-to-market gains on bond holdings. Excluding banks, insurers and brokerages, earnings growth at real-economy companies was only 2.2 percent.
Beijing has repeatedly pledged to help smaller private businesses, which have born the brunt of an escalating trade war and the government’s corporate deleveraging campaign. Its grand promises have yet to filter down to their bottom lines, though. The smaller a company is, the uglier its earnings tend to be. The 50 largest firms listed in Shanghai, mostly state-owned enterprises, notched 11.1 percent profit growth last quarter; their counterparts on the ChiNext board registered a decline of 13.6 percent.
When an economy is on red alert, cash is king – yet cash remains difficult to come by for China Inc. While earnings are growing, operating cash flow isn’t. This could partly reflect firms using non-cash items to window-dress their accounts. Still, it may signal deeper problems: Cash collection is a long-standing issue in China. Companies often see payment delays, especially those servicing the public sector.
And however hard the bureaucrats try, they can’t stop the slide in return-on-equity, a measure of how efficiently companies use shareholders’ capital to generate more earnings. Trailing 12-month ROE for non-financial firms fell to 6.7 percent in March quarter, the lowest in at least eight years.
To be fair, it’s a tough problem. Firms have different reasons for declining ROEs: DuPont analysis shows that slowing asset turnover is the issue for large caps, which are often SOEs; for smaller firms, squeezed profit margins are the culprit. So officials need to be mindful of a nation running at two speeds, one plagued by overcapacity and the other vulnerable to the ups and downs of China’s credit cycle.
Consider this year’s rally. It took off only after the People’s Bank of China announced a reserve ratio cut in January. Gains stalled in mid-April when traders started to realize the central bank wasn’t willing to open the floodgates. Then, as first-quarter results started to appear, alarm set in. There’s no easy fix for anemic earnings, which Ministry of Finance stimulus packages and central bank easing have failed to revive.
When the taps are open and money flows freely, profits hardly matter. When times get tougher it’s a different proposition. In such conditions, it’s understandable that investors cling to the security blanket of large companies and growing earnings.
To be sure, most listed companies aren’t directly exposed to trade tensions – sales from the U.S. account for only 4.3 percent of their total revenue. However, given how fragile the Chinese economy already is, any negative exogenous shock – even in the form of a tweet or two – can tip the boat over.
Many of us have been here before. Euphoria sets in after only a few glasses of bubbly, but the morning after we’re left with a headache. Of course, the best remedy for a hangover is to stay hydrated, and thankfully the PBOC has plenty of liquidity to dispense. Until it decides to do so, investors will be holding their heads – and their value stocks.
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Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron’s, following a career as an investment banker, and is a CFA charterholder.