Are Chinese and other companies in emerging markets finally getting the respect they deserve? Historically, they’ve traded at a discount on all metrics of valuation—typically, in the range of 20 to 30 percent. Even as the underlying Chinese economy developed and the shares of these companies became a commonly accepted investment option, neither institutional nor retail investors quite shook the perception that such securities were generally risky. Yet if the Asian financial crisis of the late 1990s reinforced that belief, the credit crisis of 2007 may have reversed it. Indeed, companies in several major emerging markets now trade at a premium to their peers in developed markets.
It’s true that in the wake of the crisis and the ensuing recession, investors have taken note of the great rebalancing of economic power, shifting from West to East, and have rethought long-held beliefs about the relative security of asset classes in both developed and developing economies. But an important question arises: have companies in emerging markets changed or just investors’ perceptions of them? The question is apt in a number of emerging markets, including Brazil, India, and Russia, but it’s particularly so in China, where the reversal in premiums is most noticeable. If these valuations reflect investors’ expectations for future growth and returns, are there valid reasons to believe that those of Chinese companies have improved through the recession? Or are investors already assuming an improvement in economic realities? Economic data suggest the latter.
A shift in valuation
In emerging markets, the historical discount of companies was generally in line with their performance. As we observed a few years ago, emerging markets may typically have exhibited higher growth but also had much lower returns on capital than their Western peers. This difference almost completely explains the difference in valuation multiples. From 2006 to 2010, our analysis found the average return on equity (ROE) of Chinese companies to be six percentage points below that of US companies—a gap that remained even when the profitability of US companies fell. This gap alone would imply a price-earnings ratio (P/E) multiple 20 percent lower. Even if companies in these markets had been growing three to five percentage points faster, their lower returns on capital still warranted a P/E discount of 10 to 15 percent relative to their developed-market counterparts. This discount has reversed in some markets in the wake of the economic crisis. Companies in China, along with those in India and Latin America, now trade at a premium to companies in developed markets (Exhibit 1).
In 2008–09, it was quite easy to write this development off as a temporary, liquidity-fueled anomaly. Investors wanted to be anywhere but developed markets. While companies in developing ones still had less transparent financial reporting and weaker governance, they generally had less risky banking systems as a result of stronger government controls. Also, governments didn’t have to prop up industrial companies, as the United States did in the automotive sector. Some major emerging markets, with their promise of high growth and lower cost bases, were perceived as safer than developed markets—though not all emerging markets were equally favored. Only China and India achieved the valuation premium for a protracted period; companies in Brazil and Russia traded at a discount to those in developed markets throughout the recession.
In China, the shift in valuations has not proved to be an anomaly. They remain at a 20 to 30 percent premium above those in the United States and the European Union—and the gap is not explained by a different industrial structure. On an industry-by-industry basis, the gap is even larger. In 2008, P/E ratios for Chinese companies in the industrial, consumer goods, and financial sectors were 9 percent lower, 22 percent higher, and 33 percent lower, respectively, than those of their US counterparts in the same sectors. In 2010, these companies had valuations 38 percent, 58 percent, and 6 percent higher than those of their respective US counterparts.
A down payment on growth
If current valuation levels are based in economic reality, we should see evidence to support them—either some indication that operating performance will improve significantly in the near future or data supporting an expectation that growth levels will continue to outpace those of companies in developed economies. The data are not convincing on either point.
In fact, given the relationship between growth and P/E multiples, Chinese companies would need significant operating improvements to justify the current valuation level (Exhibit 2). Their returns on capital haven’t materially changed in the past decade (Exhibit 3), and very few sectors or company types have experienced a major improvement in returns on capital. When goodwill is included, the returns of Chinese companies continue to lag behind those of their US and EU counterparts by around 2 to 3 percent on average—about as much as they have for the past decade. When goodwill is excluded, the gap rises considerably: from 1999 to 2004, the returns on capital of US companies were, on average, six percentage points higher. Since then, our analysis finds that the gap has risen to between 13 and 14 percent.
If valuation levels are not based on improved operating performance, they are, in effect, a down payment on expected growth. And it’s true that in this respect, Chinese companies have outperformed their counterparts in the United States and Europe for the past few decades. Yet since the crisis, there has been a general moderation in expectations for growth in corporate earnings and GDP in both the United States and China.
In fact, the gap between expected growth in the United States and Europe and in China is almost the same today as it was before the recession. This fact should come as no surprise. Chinese companies will have significant opportunities to export to developed markets for years to come; the crisis did not change their potential for growth in domestic markets; and many of them are now past the initial stage of rapid expansion. Over the short term, during the next few years, expected corporate earnings growth is actually about the same in China as in the United States and Europe. In the longer term, the gap between forecast US and Chinese growth is not much different from pre-crisis levels.
Living up to expectations
It’s possible that Chinese companies will make good on these higher expectations. Certainly, it will help if they can deliver the levels of growth that some analysts forecast. But growth alone won’t be enough; companies will need to improve their returns on capital as well.
Chinese managers interested in improving their returns will, in general, have to be more disciplined in thinking about how effectively their different businesses and growth opportunities use capital. That won’t be easy. A few companies are becoming more thoughtful about the way they prioritize investments and are bringing greater discipline to decision making. But when capital is freely available and the size of a company determines the personal importance of its managers—as is the case in China—the motivation for discipline in the use of capital is often weak.
Investors and stakeholders also have a critical role to play. The government is already exerting considerable administrative pressure on state-owned enterprises to improve their capital efficiency: on average, these enterprises lag significantly behind private-sector ones in returns on capital. The government can exert this pressure through the banking system, which remains the principal supplier of capital to the Chinese economy, and also through the State Council’s State-owned Assets Supervision and Administration Commission (SASAC), the agency that represents the government as shareholder in the state-owned companies. SASAC has for several years been working actively with its portfolio companies to improve their discipline in using capital. Public-market shareholders can also play a helpful role. If the importance of an issue like investment discipline is regularly reinforced through dialogue with companies, it will gradually move up the management agenda.
Companies hoping that stricter management of the corporate portfolio will improve returns might also employ a tool underutilized by even Western companies: divestitures and the restructuring of portfolios. Yet domestic M&A activity in China is extremely low by any metric, and divestitures by conglomerates are extremely rare. There is a potentially significant value creation opportunity here: divestitures create more value for the selling company’s shareholders than for the buyer’s, and sellers are more likely to get top dollar if they divest while a business is still strong. Our perspective is that selling noncore businesses isn’t a mark of failure or poor management—it’s a sign that managers are actively making a practical trade-off between increasing a company’s size and managing it more efficiently, which is what the markets are suggesting.
The Chinese government is mindful of these issues, which underlie much of the SASAC’s work to improve the performance of state-owned companies as well as the plans to create active bond and equity markets, reducing the banking system’s role in capital intermediation. The former creates pressure through administrative measures to use capital more effectively, and the latter uses market forces to encourage a more efficient allocation of capital and, by extension, to impose greater discipline on companies. This has been an objective of the State Council since the 11th five-year plan, in 2006, but events from 2007 onward slowed its progress. It’s likely to be back on the agenda in the 12th five-year plan, and the current focus on controlling inflation and domestic liquidity is also raising awareness that too much freely available capital can have unpleasant side effects.
It’s a critical moment for Chinese companies, whose valuations are high even as many reach the point where growth inevitably slows. Investors apparently remain confident that companies will be able to raise their operating performance, at least for now.