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Buffett Indicator Points to Much Higher Future Returns in Chinese Market

The valuations and performance of China and the U.S.'s markets could not be more different

In the midst of the trade war between the U.S. and China, the stock markets in both countries are experiencing volatile ups and downs, as if they are echoing the mood of President Trump. However, if you look past that, the valuations and performance of the two markets could not be more different. As the U.S. market keeps flirting with a new high that is more than 90% above its housing bubble peak in October 2007, China’s stock market is at less than half of the all-time high it reached at about the same time.

In the meantime, the economy of China has quadrupled since 2007, while the U.S. economy has grown only about 50%. As pointed out by Warren Buffett (Trades, Portfolio), the most successful investor ever, the ratio of a country’s total market cap over its gross national product (GNP) is the single most important indicator of its market valuation. The ratio of total market cap over GNP is thus called the Buffett Indicator. The much lower overall Chinese market index coupled with a much bigger Chinese economy means an even lower Buffett Indicator for China’s market, and thus a lot more investing opportunities. But first, let’s look at the historical Buffett Indicator for the Chinese market and see where it stands now in relation to its historical values.

To calculate the Buffett Indicator for China’s market, we need the total market cap of the Chinese stock market, for which we use the Shanghai Exchange Composite Index as a proxy. The index is proportional to the total of the market capitalizations of all the companies that trade on the Shanghai Stock Exchange. While the index does not include the Chinese companies that trade in Shenzhen and other markets, we assume that the long-term performance of Shenzhen and other markets is close to the Shanghai market, or their contribution is insignificant relative to the total market cap. We can see that the performance of the Shenzhen Exchange Composite Index is indeed close to that of the Shanghai Composite Index. For GNP, we use GDP instead, which should be a good proxy, too. With this calculation, we will get the relative historical ratio of the Buffett Indicator for China’s market. If we further assume that the ratio will revert to its mean, we should have a rough idea of what the Chinese stock market will return over the next eight to 10 years.

The chart below is the Buffett Indicator for the Chinese market. The detailed calculation can be found here. Just as I pointed out before, the current Chinese market valuation is only about one-eighth of what it was at the peak in 2007. Since then the economic growth of China has lowered the market valuation by a factor of four, and the market decline since 2007 contributed another factor of two. At the market peak in 2007, industry-leading companies such as Kweichow Moutai (SHSE:600519) were traded at a P/E ratio of almost 100. Today they are at a much lower valuation. From the standpoint of market valuation, now is definitively a much better time to invest in China’s stock market.

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From the current valuation and its historical values we can estimate the future projected return of the market by assuming the valuation will revert to its historical mean over the next market cycle and the economy will grow at a similar pace in the future. To be even more conservative, we will assume that the economic growth of China will slow as the country gets bigger, and the market valuation will revert to only half of its historical mean since 1991. With this conservative valuation, the Chinese market is still expected to deliver an average return of 15% a year over the next eight to 10 years.

As a comparison, the Buffett Indicator for the U.S. market is now at close to an all-time high, and the market is thus significantly overvalued, as shown in the chart below. At this valuation, the U.S. market is positioned for almost no returns over the next eight to 10 years. Therefore, China’s market is most likely a much better place to be for the next several years. For more details about the Buffett Indicator for the U.S. market and its projected returns, please visit the GuruFocus Buffett Indicator page.

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To reduce the risk of investing in China’s market, we want to focus on the companies that have non-cyclical and low-capex-requirement businesses, as well as great balance sheets, high profit margins, reasonable growth and demonstrated long-term profitability, as screened by this customized GuruFocus All-In-One Screener. These are a few companies that have passed our screen and have P/E ratios of less than 20.

Dong-E-E-Jiao Co. Ltd. (SZSE:000423)

Dong-E-E-Jiao Co. Ltd. is a company that makes Chinese medicine, health products and biological drugs. The stock price has been cut in half due to slowing growth, recent lower inventory turnover and higher accounts receivable. The company has a long-term operating margin of more than 35% and almost no debt. It is currently traded at a P/E of 13, and apparently the market is very pessimistic about the company.

Hangzhou Robam Appliances Co. Ltd. (SZSE:002508)

Hangzhou Robam Appliances Co. Ltd. makes household electrical kitchen appliances in China. The company has been highly profitable every year over the past 11 years. The long-term growth has been phenomenal, although it slowed lately. The company has no debt and is enjoying a growing operating margin, which is around 24% currently. The P/E ratio stands at 16.

Ningbo Ligong Environment and Energy Technology Co. (SZSE:002322)

Ningbo Ligong Environment and Energy Technology Co. is engaged in the research, development, design, manufacture and distribution of high electric voltage online monitoring products. The company has a strong balance sheet and reasonable growth, and enjoys an operating margin of more than 40%. It has been profitable every year over the past decade. The stock is traded at a P/E of 16.

For the complete list of the stocks that passed the screener in China, the U.S. and other markets, please go to this customized All-In-One Screener.

Disclosure: Among the stocks mentioned in the article, the author owns Kweichow Moutai.

About the author:

GuruFocus
Charlie Tian, Ph.D., is the founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

Rating: 5.0/5 (4 votes)

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Comments

Cowboy77
Cowboy77 - 3 months ago    Report SPAM

Good article and it may prove to be correct but the problem is that you can't trust the accounting or the books of a Chinese company. There was an at length interview a couple of years ago in Barrons with some highly respected accountant that everyone looked up to. He said he has no faith whatsoever in the financial statements of any Chinese company. Face it, they're just Commie's doing what Commie's do....lying, stealing and cheating. Until they want to participate fairly with the world on a trusted basis it's all just a tempting crap shoot.

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