Focus on earnings not valuations, says JPMorgan
The US bank remains bullish on Asian equities for 2008, projecting a fifth straight year of gains for regional markets.
Having correctly projected in September that the Hang Seng Index would reach 29,000 thanks to strong liquidity inflows, JPMorgan is now sticking its neck out suggesting there is still room for Asian equity valuations to rise. The investment bank’s current 2008 year-end target for the HSI is 35,000 points, indicating more than a 20% upside from current levels.
The bank’s other forecasts for next year include a 22,000-point call for the H-share index, indicating a 24% upside; and a 22,500-point target for the Mumbai Sensex index which is 18% above where it is trading at the moment.
Given that the Asia-Pacific ex-Japan indices are up 40% year-to-date and the 12-month forward price-to-earnings multiple of the MSCI Emerging Markets Free index has increased to 14.5 times from 8.2 times in the past five years – leaving it 2.7 standard deviations above the five-year average - one could argue that this is a pretty bold statement.
Most Asian equity markets have also seen very rapid gains since their August lows, which has caused concerns in some camps that a broader correction is due. Indeed, in a 2008 equity outlook report published last week, JPMorgan itself highlights that the risks for emerging markets is shifting from fundamental volatility to valuations.
“No one feels comfortable with the valuations today, because they are back to where they were in the very early-1990s,” remarks Adrian Mowat, chief Asian and emerging markets equity strategist at JPMorgan.
However if you want to keep running as winners, he said at a media briefing last week, “don’t use valuations to trigger a sell. Use concerns about earnings”.
Instead of getting stuck on valuations, Mowat prefers to focus on the issue of why Asia became so expensive in the first place. “Conditions that caused markets to become more expensive also generated more earnings growth. Have these conditions changed? I think the answer is that they haven’t changed and they have got even stronger.”
Accordingly, as the drivers of the re-rating over the past 12 months are still in place, Asian P/E multiples could rise further, he argues.
Global drivers of the re-rating include: a broadening of the investor base, notably through the Qualified Domestic Institutional Investor (QDII) scheme which is allowing Chinese institutional investors to buy overseas stocks; a convergence in risk free rates; and an expanding economic growth premium between emerging markets and the countries within the Organisation for Economic Co-operation and Development (OECD).
At a country level there are also other drivers such as low real interest rates, currency appreciation which discourages capital outflow, reform of the long-term savings industry and the improving historical performance of local equities.
According to Mowat, the average emerging markets company is expected to generate 16% earnings per share growth over the next 12 month, which is still pretty high.
“Our advice is to continue to pay up for growth. It is premium growth that attracts investors to emerging markets. This trend is increasing as local savers increase their exposure to equities,” the report states.
By the same token, companies that are growing at less than 10% may continue to underperform even if they trade at cheaper valuations, and companies that fail to deliver on growth are likely to de-rate quickly.
Mowat remains bullish on China, which is now one of the most expensive markets in the region. Against a forecast that China’s nominal gross domestic product will reach 14.1% next year, the strategist feels comfortable to say Chinese equities could attain an earnings growth of 20%. The ongoing strengthening of the Chinese currency should also help attract investors to Chinese stocks in Hong Kong as their earnings will be worth more when converted into Hong Kong dollars.
“When we look at H-shares and red chips, (many of them) are denominated in Hong Kong dollars. And 5% renminbi appreciation seems reasonable,” he says.
Mowat argues that productivity in China is under-reported. A couple of years ago when the renminbi first started to appreciate, margins came under pressure, which resulted in bottom line growth of the country’s top 5,000 companies generally lagging top line growth. Chinese corporations are of huge scale and traditionally very labour intensive. However, by making use of low borrowing costs to and hiring machines instead of labour, the improved productivity could drive profit growth in excess of nominal GDP growth.
Other forces driving up the H-share market, according to JPMorgan, include the potential for a convergence in valuations of H-shares and redchips on the one hand and A-shares on the other, through the expanding QDII programme. As the Chinese authorities encourage more domestic listings, Mowat notes there is a lack of H-share supply in the market.
Overall, the bank is overweight Hong Kong, Malaysia and Thailand in the region and has upgraded India to neutral. As Taiwan and Korea are more exposed to consumer demand in the OECD countries, which is expected to soften, the bank has downgraded these countries to underweight.
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