2018 A-Share Market Strategy

Transcription

1 Equity Research 2018 A-Share Market Strategy Favor high growth mid-caps that are improving their product offerings Alex Fan, CFA SFC CE No. ADJ With contribution from the GF A-share research team GF Brokerage Limited 29-30/F, Li Po Chun Chambers 189 Des Voeux Road Central Hong Kong High growth of mid-cap stocks to regain market favor Due to expectations for neutral liquidity conditions, we will still see opportunities from just certain sectors in 2018 (as opposed to an across-the-board market rally). With the peaking and subsequent slight decline in interest rates, lower discount rates will favor mid-cap stocks, which have faster earnings growth compared with their relatively high valuations. As such, we expect share price outperformance to extend from large-cap sector leaders to mid-cap leaders in their corresponding sub-sectors. Liquidity to determine the structural trend of the A-share market China funds outstanding for foreign exchange and credit financing growth are set to remain stable, while still relatively high real interest rates and the relatively weak wealth effect of the A- share market will stop household savings from flooding the stock market. Besides, increasing investment returns have led to a rise in long-term financing needs from companies. Considering the limited increase in liquidity, Chinese households prefer low risk money market instruments to high-risk equity products. A-share earnings growth to slow; interest rates will fall after peaking We expect earnings growth for A-shares and A-shares ex-financials of 8% and 15% respectively in 2018, while ROE will decline slightly given lower sales margins and asset turnover ratios. Inflation will rise and then fall, seesawing around 2.4%. Interest rates will remain high given tightened financial deleveraging, but should decline slightly with the announcement of detailed financial supervision policies around 2Q18. As regulation will be more market driven going forward, risk appetite in the A-share market is set to improve slightly. Slightly lower discount rate favors the growth premium of mid-caps In 2017, investors favored large cap stocks with high earnings certainty rather than high growth mid-to-small cap stocks. However, mid-cap stocks are now more attractive given their 44.3% earnings growth in 9M17 and 26.5x P/E valuation, compared with just 11.6% earnings growth and 12.7x P/E for large-cap sector leaders. We believe mid-cap stocks (market cap of Rmb20-70bn) will outperform together with large-cap industry leaders in 2018 given lower discount rates. Sector allocation We favor sectors that are optimizing existing capacity (technological upgrades - professional equipment, electronic equipment and transportation equipment; lowering financial risks property and financials) and increasing the quality of their products/services (high-end capacity expansion midstream manufacturing; beautiful life consumption upgrade retail, healthcare). Themes 1) Deleveraging property leasing, 2) genuine technological innovations AI, fintech, advanced manufacturing, healthcare, OLED, new energy/new energy vehicles, 5G technology. Risks Unexpected inflation pickup leading to monetary policy change; rising interest rates due to continued stringent financial supervision.

2 Share price strength limited to certain sectors in 2018 Earnings were the core variable in 2017, sector leaders outperformed Supply-side reform and property inventory clearing have lowered China s long term risk premium, with the CDS rate reaching a historical low. Meanwhile, renminbi appreciation and a widened interest rate gap between China and the US have attracted fund inflows to the A-share market. Thanks to the structural adjustments from 2011 to 2015, which increased industry concentration, earnings growth rate for sector leaders comfortably outperformed the sector average. On the other hand, due to the unexpected high GDP growth rate and stringent financial supervision in 2017, rising interest rates weighed on stocks with high valuations. As such, large-cap blue chips were favored driven by rising earnings and valuation re-ratings, while small-cap stocks were dragged down by high valuations. Figure 1: Profitability of sectors leaders outperformed their sectors (3Q17) Figure 2: Rising interest rates weighed on stocks with high valuations Sources: Wind, Bloomberg, GF Securities Development and Research Centre, GF Liquidity will be the core variable in 2018, and we will still see a market where just a few sectors manage to post strong share price gains In the past, high earnings and high liquidity have both been indispensable elements of a bull market. Given expectation for a slowdown in A- share earnings in 2018 and neutral liquidity, we are unlikely to see a bull market. We believe the situation in which just a few sectors manage to post strong share price gains will continue during Figure 3: Dividend discount model comparison Figure 4: Supply and demand of liquidity in 2018 Stable liquidity supply and rising liquidity demand in the real economy will lead to neutral liquidity in the A-share market next year First, due to slowing economic growth in developed countries, renminbi appreciation and a narrowing of the US/China interest rate spread, China s 2

3 funds outstanding for foreign exchange are unlikely to expand in Second, considering MPA assessment, new asset management regulations and low excess deposit reserve ratios, social financing and credit financing growth will remain stable. Third, the inclusion of A-shares in the MSCI brought substantial liquidity to the A-share market in 2017, hence marginal growth in actively allocated funds may slow. Lastly, household savings are unlikely to flood into the stock market in 2018 given still relatively high real interest rates and the fact that individual investors would struggle to make profits from the A-share market with the number of money-losing stocks more than triple that of money-making stocks. For liquidity demand, on the one hand, real economy investment returns have rebounded since 2H16, and thus construction is expected to expand in late 2017 or early 2018, which would stimulate long-term corporate financing demand. On the other hand, stringent new regulations on asset management are likely to direct funds with low risk appetite from high risk equity funds to low risk money funds or insurance products. Hence, we believe liquidity conditions in the equity market are unlikely to improve next year. Figure 5: Low excess deposit reserve ratio restricts social and credit financing growth Figure 6: China and US interest rate (10-Y) spread is unlikely to widen Figure 7: High real household saving interest rate Figure 8: Money-losing stocks vs money-making stocks as of Nov 30, 2017 Sources: Wind, Bloomberg, GF Securities Development and Research Centre, GF Earnings growth to slow; interest rates to begin to drop in 2H18 Earnings growth to slow Earnings growth is likely to slow down in 1H18 due to the down-cycle in the property market and a high earnings base in However, a turning point is expected in 2H18, supported by a pickup in manufacturing investment growth and the end of the period of cuts to inventory. We expect earnings growth for A-shares (ex-financials) of around 15% in 2018, down from 25% in Besides, historically, the asset turnover rate is likely to decline during a stock clearing cycle, which could lead to a lower ROE next year. 3

4 Figure 9: Property down-cycles usually drag down A- share earnings Figure 10: A-share earnings bottom out before the end of a period of inventory cuts Figure 11: A-share earnings projections But limited room for higher interest rates We do not see much room for interest rate to rise further next year. First, the CPI next year is expected to be around 2.4%, a level which will not lead to tightened biases in monetary policy. Second, given the MoM declines in property prices in firsttier cities since Aug, loan growth has significantly declined. With the detailed version of the new regulations on asset management likely to be published around 2Q18, financial supervision may begin to be relaxed to some extent, leaving room for interest rates to stabilize and settle at slightly lower rates. Figure 12: The determining factors of interest rates Figure 13: Interest rate likely to dip after details of financial supervision regulations announced Sources: Wind, GF Securities Development and Research Centre, GF Note: Dotted lines in Fig.13 after 2017 are GF forecasts 4

5 Mid-cap stocks value emerging as discount rate flattens Lower discount rate in 2H18 favors growth premium of mid-caps Investors favored a certainty premium (stocks with relatively high earnings certainty) and liquidity premium (stocks with relatively higher liquidity) and neglected the growth premium (stocks with relatively higher earnings growth) due to the high discount rate in While the discount rate is expected to decrease slightly in 2018, the present value of cash flows will increase. In 9M17, earnings growth for mid-cap stocks was 44.3%, and they had a 26.5x P/E valuation, attractive compared with just 11.6% earnings growth and 12.7x P/E for large-cap sector leaders. As such, besides large-cap sector leaders, we believe mid-cap stocks with high earnings growth and reasonable valuations will also outperform. Figure 14: Quarterly accumulative earnings growth for mid-caps and large-caps Figure 15: Declining valuations for mid-caps Sector recommendation from the angle of supply side quality improvements The focus of supply-side reform is shifting from supply quantity cuts to supply quality improvement Supply quality improvement mainly involves in two factors: 1) optimizing existing resources, and 2) increasing high quality supply. The first issue involves (i) technology enhancements in key manufacturing industries, with transportation equipment, electronic equipment, healthcare and professional equipment sectors showing the strongest R&D input, as well as, (ii) inventory optimization (such as property leasing and REITs) which can effectively lower financial risks, making the property and finance sectors attractive. In terms of high quality supply increases, we believe midstream manufacturing industries (such as basic chemicals, construction materials and general machinery) are starting a new round of high-end capacity expansion, while the retail, healthcare and media sectors are seeing significant demand growth given the rapidly expanding middle class under the government s drive towards providing a beautiful life. 5

6 Figure 16: Supply-side quality improvement Optimizing existing resources Technology enhancement in key manufacturing industries Inventory optimization Electrical equipment Electronics Finance Property Supply quality improvement Increasing high quality supply A new round of high-end capacity expansion Mechanical Chemical industry Beautiful life consumption upgrade Retailing Healthcare services Investment themes - quality revolution in a new era Investment themes for 2018 With the increasing participation of institutional investors in the secondary market, improving regulations in the equities markets, and increasingly rational behavior of PE/VC investors, the A-share market has entered a new era, in our view, with the rising importance of industry-based themes and declining importance of concept themes. In 2018, we embrace the quality revolution, in particular in terms of 1) reforms in existing industries and 2) new industries with genuine technological innovations. In particular, 1) the property leasing sector is set to benefit from financial deleveraging in the property sector, 2) AI, fintech, advanced manufacturing and healthcare, which have gained renewed attention in the primary market, and 3) high growth expectations in new energy/new energy vehicles, OLED and 5G technology. Figure 17: Quality revolution in a new era 6

7 Rating definitions Benchmark: Hong Kong Hang Seng Index Time horizon: 12 months Company ratings Buy Stock expected to outperform benchmark by more than 15% Accumulate Stock expected to outperform benchmark by more than 5% but not more than 15% Hold Expected stock relative performance ranges between -5% and 5% Underperform Stock expected to underperform benchmark by more than 5% Sector ratings Positive Sector expected to outperform benchmark by more than 10% Neutral Expected sector relative performance ranges between -10% and 10% Cautious Sector expected to underperform benchmark by more than 10% Analyst Certification The research analyst(s) primarily responsible for the content of this research report, in whole or in part, certifies that with respect to the company or relevant securities that the analyst(s) covered in this report: (1) all of the views expressed accurately reflect his or her personal views on the company or relevant securities mentioned herein; and (2) no part of his or her remuneration was, is, or will be, directly or indirectly, in connection with his or her specific recommendations or views expressed in this research report. Disclosure of Interests (1) The proprietary trading division of GF Brokerage Limited ( GF ) and/or its affiliated or associated companies do not hold any shares of the securities mentioned in this research report. (2) GF and/or its affiliated or associated companies do not have any investment banking relationship with the companies mentioned in this research report in the past 12 months. (3) Neither the analyst(s) preparing this report nor his/her associate(s) serves as an officer of the company mentioned in this report and has any financial interests or hold any shares of the securities mentioned in this report. Disclaimer This report is prepared by GF. It is published solely for information purpose and does not constitute an offer to buy or sell any securities or a solicitation of an offer to buy, or recommendation for investment in, any securities. The research report is intended solely for use of the clients of GF. The securities mentioned in the research report may not be allowed to be sold in certain jurisdictions. No action has been taken to permit the distribution of the research reports to any person in any jurisdiction that the circulation or distribution of such research report is unlawful. No representation or warranty, either express or implied, is made by GF as to their accuracy and completeness of the information contained in the research report. GF accepts no liability for all loss arising from the use of the materials presented in the research report, unless is excluded by applicable laws or regulations. Please be aware of the fact that investments involve risks and the price of securities may be fluctuated and therefore return may be varied, past results do not guarantee future performance. Any recommendation contained in the research report does not have regard to the specific investment objectives, financial situation and the particular needs of any individuals. The report is not to be taken in substitution for the exercise of judgment by respective recipients of the report, where necessary, recipients should obtain professional advice before making investment decisions. GF may have issued, and may in the future issue, other communications that are inconsistent with, and reach different conclusions from, the information presented in the research report. The points of view, opinions and analytical methods adopted in the research report are solely expressed by the analysts but not that of GF or its affiliates. The information, opinions and forecasts presented in the research report are the current opinions of the analysts as of the date appearing on this material only which may subject to change at any time without notice. The salesperson, dealer or other professionals of GF may deliver opposite points of view to their clients and the proprietary trading division with respect to market commentary or dealing strategy either in writing or verbally. The proprietary trading division of GF may have different investment decision which may be contrary to the opinions expressed in the research report. GF or its affiliates or respective directors, officers, analysts and employees may have rights and interests in securities mentioned in the research report. Recipients should be aware of relevant disclosure of interest (if any) when reading the report. Copyright GF Brokerage Limited. Without the prior written consent obtained from GF Brokerage Limited, any part of the materials contained herein should not (i) in any forms be copied or reproduced or (ii) be re-disseminated. GF Brokerage Limited. All rights reserved /F, Li Po Chun Chambers, 189 Des Voeux Road Central, Hong Kong Tel: Fax: Website: 7