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Making sense of ultra-cheap Chinese stocks

Updated: Feb 14, 2023


In this research note I will focus on several Chinese stocks which are unjustifiably cheap (Table 1). (Note: OQFM uses more sophisticated value factors than the ones listed in the table; these factors are used for illustrative purposes).


Table 1: Cheap Chinese Stocks

Source: OQFM


Cheap stocks, however, can be value traps due to their growth and risk profiles.

OQFM measures growth using a range of factors that measure whether a company’s historical and forecast financial data is trending up or down, and the nature of the trajectory. The non-systematic overlay also facilitates an examination of each company’s operations to identify future growth impediments such as structural challenges.


OQFM measures risk based on numerous quantitative criteria, including:

  • Return volatility and market beta to assess return profiles,

  • Debt protection factors to measure solvency risk,

  • Earnings relative to cashflows to identify potential earnings manipulation,

  • Earnings forecast dispersion and time series volatility to measure certainty risk, and

  • Stock turnover to measure liquidity risk.

This risk analysis is supplemented with a review of regulatory risk and governance issues.


Regulatory risk is usually industry specific. In China, for example, property stocks are frequently affected by government policy. More recently, internet stocks have come under the purview of the CCP.


Analysing governance issues is more complex. There are, however, various “red flags” that can be monitored including a change in auditor, qualified audit opinion, number of independent directors, and an audit committee which lacks a financial expert.


So how do the aforementioned Chinese stocks rate based on growth and risk?


The companies’ growth profiles are mixed (Chart 1) but none of the companies have exceptionally weak composite growth z scores. China Mobile (941 HK) has the weakest score as its historical earnings and cashflow growth has been constrained by significant 5G capex. However, the growth composite is only 0.5 standard deviations below the mean.


Chart 1: Composite Growth Z Scores

Source: OQFM


Based on quantifiable risk criteria, the companies generally rate well. Chart 2 shows the companies’ composite certainty and debt protection z scores.


Chart 2: Composite Certainty and Debt Protection Z Scores

Source: OQFM


The stocks’ market betas (based on six months of daily data) are also well below 1, ranging from 0.39 for Shanghai Industrial to 0.70 for China Communication Services.


Market turnover for all the stocks is also extremely high and there is no liquidity risk.


One issue impacting the companies in Table 1 is majority ownership by Chinese Government entities. However, this issue impacts numerous listed Chinese stocks, including many stocks which are richly valued, including the largest constituent of the China A50 Index (Kweichow Moutai) which is trading on a PE multiple greater than 50. Government interference is potentially a bigger issue for China Mobile given the strategic importance of telecommunications. China Mobile also has a very large net cash position which accounts for approximately 50% of its market capitalization but it is unlikely the Chinese Government would allow this cash to be distributed to shareholders.


Two companies listed in Table 1 are also subject to US sanctions (China Railway Construction and China Mobile). I addressed this issue in a previous research note and concluded that the sanctions are largely a short-term liquidity issue resulting from US investors’ need to sell their holdings. The companies are largely domestically focused and do not need access to US capital markets for funding. Put differently, the US sanctions do not have a material impact on the companies’ fundamental valuations.


It is also worth noting that 1186 HK (China Railway Construction) traded at a 45% discount to its listed ‘A’ share as at the end of April and that 941 HK (China Mobile) has applied for an ‘A’ share listing which is likely to be approved.


Putting it all together, there is no doubt the companies listed in Table 1 are extremely cheap based on a range of valuation metrics. Quantifiable growth and risk data are generally robust. As identified, there are issues not captured in the quant factor scores which probably warrant a market discount. However, it is very difficult to justify the extreme valuation scores, particularly given the bullish market sentiment which has driven many equity markets to their most expensive levels ever.


In an environment where irrational exuberance is becoming more commonplace it’s nice to know that there is some irrational pricing at the other end of the value spectrum. The Fund has long positions in all of the stocks in Table 1 and in many cases the positions are relatively large, exceeding 1% of AUM.

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