Recent volatility on the Chinese stock market is a timely reminder that, in the shorter term, share prices depend on many factors—not least of which are sentiment and speculation.
But, rather than blindly accepting the bearish consensus on Chinese shares, investors should rationally assess individual companies.
When markets get bumpy, step back and remember the most important determinant of long-term equity returns is the relationship between the price paid for a share and its intrinsic value (the price a rational person, with all the facts about the business, would pay).
Intrinsic value doesn’t change much over short periods; it’s share prices that fluctuate alongside extremes in investor emotions. Occasional stock market panics are to be expected, and, while they’re uncomfortable, they also can create attractive opportunities for patient long-term investors.
That’s not to say current market conditions make all Chinese shares attractive. Prices for some issues can remain well above their intrinsic value following a prolonged bull market, and sometimes price declines correctly reflect weaker company fundamentals.
Valuable Companies
But, in some instances, market pessimism has gone beyond what company fundamentals justify.
Take Baidu, a leading Chinese Internet company. It lost 25% of its market value in July and August, yet its long-term worth didn’t experience a commensurate decline. In late August, the company’s market value was 10 times the earnings of its core search business, which will likely keep growing more than 20% annually. While the company’s newer initiatives, which include video and online travel, are currently loss-making, they hold considerable long-term potential.
Another example is NetEase, one of China’s largest online gaming operators and a high-quality business that was overly punished during the recent volatility. Like Baidu, NetEase stands to benefit from greater mobile and Internet penetration, and near-term economic weakness is unlikely to prevent people from playing its games. With more than 20% of its market capitalization held in cash, the company can withstand shortterm headwinds. It will likely grow its profits at a double-digit annualized rate over the next five years.
It’s Not That Risky
The perception that risks associated with investing in China are inherently higher is also misguided. While the macroeconomic risks in China are real, I believe they’ve already been reflected in the prices of selected shares. Overpaying for an asset is the greatest long-term risk investors face, which means investing is riskiest when sentiment is positive and share prices are high. By contrast, when market turmoil pushes asset prices below their intrinsic values, the risk of losing money is lower.
Furthermore, a business isn’t inherently safe simply because it operates in an economically robust environment. It’s arguably less risky to own a high-quality company with a strong balance sheet in China than a mediocre or heavily indebted one in the U.S. or Canada.
Attempting to time a rebound in Chinese shares is a fool’s errand. But, it would be equally foolish to avoid high-quality Chinese companies simply because the wider Chinese market may experience short-term volatility.
Craig Bodenstab is an investment counsellor at Orbis Investments. c.bodenstab@orbis.com
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