Guest post courtesy of Kemp Dolliver, CFA, Chief Investment Officer for Cherrystone Hill Capital Management LLC.
MSCI announced in June that it will add a small (0.7%) weighting in China’s A-shares to the MSCI Emerging Markets Index and the MSCI ACWI Index in two installments in May and August 2018. The decision is an important positive for China’s capital markets (particularly given MSCI’s prior rejections), but we greeted the news with a yawn. We have had access to A-shares through the Shanghai Connect and Shenzhen Connect, but haven’t invested through them. Like other investors, we’re wary of the government’s heavy-handedness and issuers’ ability to halt trading in their securities for extended periods of time.
Mainland Healthcare Valuations Are Generally Unappealing
These concerns are important, but secondary to our main concern, which is valuations. The average trailing P/E ratio of the 250+ healthcare companies traded on the Shanghai and Shenzhen exchanges is 78x (I kid you not) while the median trailing P/E is 46x. In comparison, the average trailing P/E ratio for the 60+ healthcare companies listed in Hong Kong is 37x (median of 19x). Some companies have issued both ‘A’ and ‘H’ shares with the ‘H’ shares trading at meaningful discounts to their ‘A’ share counterparts. You have a choice: which would you choose?
The quality of the mainland companies is highly variable, but there is a subset that has established credibility through licensing deals and other transactions with multi-national companies. As a check on our thinking, we’ve engaged in an exercise several times with these companies where we look for a justification for the P/E’s: Depressed margins? No. Rapid long-term growth rate? No. Extraordinary returns on capital? No. Hard to make a good investment case here.
Innovation on the Mainland is Undervalued
The unfortunate result of this state of affairs with ‘A’ shares is overvaluation of current earnings and undervaluation of innovation (which drives future earnings). We have read numerous broker reports where the present value of a company’s R&D pipeline (no matter how impressive) is an insignificant portion of the share price. When the market (rightly or wrongly) values your business at 45-50x current earnings, all the good news is in the price. In addition, some analysts have commented on the pushback received from investors who point out that there are better values in other markets. It is a tough sale.
The year-to-date returns of the ‘A’ shares compared to ‘H’ shares suggest that it’s best to go with the better values. The universe of healthcare ‘A’ shares is flat YTD with several stocks up 70%. The universe of healthcare ‘H’ shares is up 15% YTD with one up 176%. Admittedly, one year doesn’t tell the whole story, but the ‘A’ shares’ valuations limit their potential.
Looking Ahead: The Looming Collision Between Rich Valuations with Broader Access
In its June announcement, MSCI stated that “ further inclusion will be subject to a greater alignment of the China ’A’ shares market with international market accessibility standards, the resilience of Stock Connect, the relaxation of daily trading limits, continued progress on trading suspensions, and further loosening of restrictions on the creation of index-linked investment vehicles.”
The big question in our mind is whether ‘A’ share valuations ever normalize with their overseas peers. If so, will the normalization result from a prolonged period of underperformance or a quick, sharp drop in prices? Government policy will be a major factor in answering the second question (remember 2015?). Regression to the mean is a powerful force and much more difficult to resist in an open market.
About the Author
Kemp Dolliver, CFA, is Chief Investment Officer of Cherrystone Hill Capital Management LLC. He has over 25 years’ experience investing in healthcare in buy-side and sell-side roles in both the US and Asia. Mr. Dolliver was Head of Healthcare Research – Asia and Managing Director of Religare Capital Markets (Singapore) Pte Ltd prior to forming Cherrystone Hill. He previously worked for Cowen and Company, Avondale Partners LLC, NationsBank (now Bank of America), Aetna, and Dean Witter Reynolds (now Morgan Stanley). Mr. Dolliver also publishes the Developing World Healthcare Blog to discuss trends and developments in this sector.