Big Trouble in Big China
Valens Research would like to share with you the Litman Letter we released last April 2016, on how Corporate China is actively destroying shareholder value through excessive growth – and why the economy and the stock market will diverge in performance.
This Litman Letter discusses our concerns about value destruction in Corporate China. While much has been said in the press about the problems with Chinese banks, we analyzed the aggregate performance of 850+ publicly-traded Chinese non-financial firms. In our analysis, we adjusted for financial statement reporting distortions to get a clear apples-to-apples comparability over time and around the world.
Sadly, the Adjusted Return on Assets of Corporate China has steadily fallen year-by-year below anyone’s measure of cost of capital. Economic profit is distinctly negative and Corporate China is destroying economic value en masse.
In the file linked below, you will find out how large the scope of this problem is, and how 70% of Chinese non-financial firms are generating a low and falling Adjusted ROA while 80% of firms continue to grow their asset base – a recipe for widespread shareholder value destruction.
We hope you find the article interesting.
Valens' equity and credit research relies on a bedrock of deep fundamental forensic analysis with a coverage of over 4,000 equities and all major corporate credit. That means “cross-capital” equities and credit research are not siloed, but instead are fundamentally aggregated and compared with orthogonal data points.
To access all our Litman Letters, click here: http://app.valens-research.com/macroeconomic-analysis/litman-letters?p=3Professor Joel Litman
Chief Investment Strategist
joel.litman@valens
-
securities.com
The Litman Letter
April 25, 2016
Big Trouble in Big China: Corporate China is actively
destroying shareholder value through excessive
growth
–
and why the economy and the stock market
will diverge in performance
•
Our concerns about value destruction in Corporate China
were highlighted in last month’s Seeking Alpha article,
Economic Suicide in China
, which garnered a number one
ranking for readership in its category, and 75+ comments
•
Much has been in the press about the problems with
Chinese banks. However, we analyzed the aggregate
performance of 850+ publicly
-
traded Chinese
non
-
financial
firms, adjusting for financial statement reporting
distortions to get a clear apples
-
to
-
apples comparability
over time and around the world
•
Sadly, the Adjusted Return on Assets of Corporate China
has steadily fallen year
-
by
-
year below anyone’s measure of
cost of capital. Economic profit is distinctly negative and
Corporate China is destroying economic value
en
masse
•
This problem is broad
-
based. 70% of Chinese non
-
financial
firms are generating a low and falling Adjusted ROA while
80% of firms continue to grow their asset base. This is a
recipe for widespread shareholder value destruction
•
Energy and materials sectors are notable culprits of this
value destruction, while consumer staples and healthcare
uniquely show signs of aggregate economic profit creation
•
It would appear that Chinese companies are choosing to
keep the overall economic pace of China strong, with
continued growth in employment and production.
However, the cost of this excess growth will be borne by
their shareholders, and market valuations will continue to
suffer for years to come
•
Likely, Chinese managers believe it’s the right choice for
China as a whole in the near
-
term. The world may benefit
from continued growth in the Chinese economy. However,
shareholders of Chinese stocks will not do so well. The
economy and the stock market are simply not the same
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First off, kudos to anyone who recognized the movie reference of “Big Trouble in Big
China,” though you are giving away your age. As a fitting opening to the results of our
research on Corporate China, here’s a quote from the protagonist Jack Burton in the cult
classic:
“I'm a reasonable guy. But, I've just experienced some very unreasonable things.”
For decades, China has focused on growing the economy as fast as possible. However, a
problem with this focus has emerged. In aggregate, this growth has become
economically unprofitable, and not just by a small margin. Chinese companies are
continuing to grow their asset bases without sufficient earnings generation to make the
growth viable.
The Litman Letter
April 25, 2016
Page
2
Our research shows that more than 70% of Chinese companies are generating a negative
economic profit. In other words, the Adjusted Return on Assets of nearly 600 of the
largest companies in China is below their cost of capital.
In many developed nations such as the United States, when business returns fall below
their cost of capital, management teams restrict asset growth. This is often met with
cheers from shareholders and higher valuations that reflect that discipline. However, this
is not the case in Corporate China, where more than 80% of firms have continued to
expand their asset base through 2015.
Performance and Valuation of Corporate China
When viewing profitability through the lens of the Performance and Valuation Prime
template, we get a clearer picture of the economics of Corporate China. Any reliable
analysis of company financial statements requires removing distortions in as
-
reported
accounting measures. As such, our adjusted measures of corporate returns provide a
more reliable, proprietary economic view of the companies studied. Once the financials
have been appropriately cleaned up for the universe of companies, we can look at their
returns in aggregate.
Profitability in China has followed a cyclical pattern, growing from 6% in 2005 to 8% in
2006
-
2007 before again fading to 6%
-
7% during the global recession. Returns then
peaked at 10% in 2010, before beginning what would become a material decline to 4% in
2014 and expected 3% levels in 2015.
This overall decline in profitability to historically low levels has been accompanied by
10+% asset growth in every year since 2007. Even as economic profit has slipped into
negative territory from 2012 to present, growth has been substantial, ranging from 11%
in 2014 to 29% in 2012, as Corporate China continues to destroy value.
Sector
-
Specific Analysis
The universe studied largely comprises firms in the Industrials, Consumer Discretionary,
and Materials sectors, with firms in those three making up over 2/3 of the overall
population.
Companies in the Materials sector have performed particularly poorly, with profitability
peaking at only 9% in 2006
-
2007, before crashing all the way to 1% this year. However,
growth has been particularly strong, peaking at +30% in multiple years, and only falling to
~10% levels in recent years. Additionally, value destruction in this sector is widespread,
with 114 of the 143 companies analyzed generating sub
-
cost of capital returns, and with
well over 50% of those firms continuing to materially grow their assets.
The Litman Letter
April 25, 2016
Page
3
Likewise, the Energy sector has seen a substantial decline in profitability, though this has
been driven by macro headwinds more than mismanagement. Nonetheless, a decline in
ROA’ from peak 28% levels in 2008 to 6% by 2013, and a decline to 2% levels in 2014
-
2015 should warrant a focus on slowing growth. However, the energy sector has grown
at substantial +17% levels since 2012, and is expected to have grown at a robust 10% in
2015 even as oil prices dropped to lows not seen since the early
-
2000s.
It
is
worth
noting
that
it
hasn’t
been
all
bad
.
Healthcare
and
Consumer
Staples
firms
in
particular
are
still
creating
value
.
The
Healthcare
sector
is
still
generating
above
-
cost
of
capital
level
returns,
though
current
trends
imply
this
might
not
last
for
much
longer,
while
firms
in
the
Consumer
Staples
space
are
still
generating
2
x
cost
of
capital
returns
.
However,
even
these
firms
are
seeing
profitability
begin
to
fade,
and
yet
are
continuing
to
grow
at
double
-
digit
levels
.
“One
wonders
if
China
is
the
new
Japan
.
”
–
Maurice
Obstfeld,
IMF
Chief
Economist
Since
the
Nikkei
peak
in
1991
,
Japan
has
seen
a
downward
roller
coaster
of
stock
market
valuations
.
That
despite
a
relentless
search
for
market
share
and
market
size
by
Corporate
Japan
.
The
fact
has
been
that
much
of
the
asset
and
revenue
growth
of
Japanese
companies
has
been
accompanied
by
returns
at
or
below
the
cost
of
capital
.
If
the
Chinese
government
and
Corporate
China
do
not
begin
to
focus
on
discipline,
and
do
not
reign
in
growth
as
profitability
reaches
unprecedented
lows,
the
stock
market
could
well
fall
victim
to
the
same
fate
that
Japan
has
had
over
the
last
2
-
3
decades
.
Crippling
debt
levels,
zombie
companies,
and
lower
investment
spending
could
drive
serious
weakness
in
China’s
economy
over
the
long
term
.
Is
China
willing
to
avoid
the
fate
of
Japan’s
stock
market?
It
depends
on
the
ability
and
willingness
of
Corporate
China
to
find
a
balance
between
pushing
the
growth
of
near
-
term
employment
and
the
overall
economy
with
the
long
-
understood
strategy
of
only
building
businesses
that
can
achieve
a
positive
economic
profit
.
For
now,
it
looks
like
near
-
term
economic
growth
is
all
-
important,
and
that
ought
to
make
investors
in
Chinese
companies
strongly
reconsider
their
ownership
for
the
long
term
.
As always, thanks for reading,
–
Joel
The Litman Letter
April 25, 2016
Page
4
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Copyright 2015, Valens Research.
All Rights Reserved. Please refer to the last page.
The Litman Letter
Joel
Litman
Chief Investment Strategist
joel.litman@valens
-
securities.com
+1 (646) 491 2601
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The Litman Letter
Joel
Litman
Chief Investment Strategist
joel.litman@valens
-
securities.com
+1 (646) 491 2601
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