Earnings disappointment may stall chase for outperforming China stocks

Earnings disappointment may stall chase for outperforming China stocks

12:44am EDT

By Clement Tan

HONG KONG (Reuters) – Chinese companies still able to report healthy profits could see their shares trim sharp gains if earnings disappoint, narrowing a yawning gap with firms struggling to cope with Beijing’s drive to consolidate industries plagued by overcapacity. The signs are starker in onshore markets where sectors such as technology and pharmaceuticals, which are still generating healthy profits, have significantly outperformed the lumbering industrials and materials firms plagued by inefficiency. Slowing growth in China is now a top concern for global investors, who have steadily cut exposure to emerging markets and braced for the risk of a possible hard landing in the world’s second-largest economy.A sub-index of information technology components on the CSI300 index of the leading A-share listings has surged almost 40 percent on the year, while sub-indexes for energy and materials have each plunged nearly 30 percent.

The large divergence raises the risk that investors are paying too high a premium in chasing earnings growth.

“The single biggest risk is (outperforming) sectors reporting underwhelming earnings. Investors have built up a lot of expectations,” said Lilian Leung, who manages the $711.2 million JP Morgan Pioneer China Pioneer A-share Fund.

Disappointment on the earnings front may trigger a derating or sell-off for these sectors, Leung added.

At the previous earnings season in April, 86 percent of healthcare and 71 percent of info-tech A-share listed companies missed expectations, according to Thomson Reuters StarMine.

The risk of investors concentrating bets on one part of the market were underlined earlier this year when dividend-yielding stocks sold off on signs that U.S. interest rates might be headed higher.

Cyclical sectors such as steel, shipbuilding and mining bore the brunt of a protracted sell-off as global investors significantly cut exposure to China following anemic economic data and a cash crunch at the end of June.

Year to date, the MSCI China .MSCICN and the CSI300 .CSI300 are each down about 9 percent, and the China Enterprises Index .HSCE of the top Chinese listings in Hong Kong has tumbled more than 15 percent.

Net outflows were recorded for the 20th time in 22 weeks in the week ended July 31, according to funds tracker EPFR. Short selling on the Hong Kong bourse has also consistently topped 10 percent in the past two months, compared with an 8 percent historical average.

VALUE PROPOSITION

That has left valuations for these cyclical at historic lows, in some cases even below those seen in the aftermath of the 2008-09 financial crisis.

In recent weeks, investors have started to dip their toes back into some large cap steel and cement stocks, which are likely to benefit from any industry-wide consolidation that Beijing pushes through.

“In the last month or two, we have been increasing our big cap exposure because we think they are already cheap enough. Some of the commodities, energy and banking names are trading at 5 times PE and offer a dividend yield of 6 percent,” said William Fong, who helps manage $3 billion worth in assets in a series of China-Hong Kong equity funds for Barings.

He declined to mention specific stocks.

In a sign of things to come, Anhui Conch Cement (0914.HK: Quote, Profile, Research, Stock Buzz) and Angang Steel (0347.HK: Quote, Profile, Research, Stock Buzz) have both touched multi-month highs in the past week. Angang is likely to post a second-straight quarter of profit growth, suggesting things may be turning around in the short term.

Given that sentiment has been so negative on China, even earnings that meet expectations could bring more people back into the market, added Barings’ Fong.