Chinese stocks are now trading at a 20% to 30% premium above competitors in the United States and the European Union, even though expected corporate earnings growth is actually about the same, say McKinsey consultants. In short, the market shows signs of being overheated.
The premium gap is even bigger in certain industries. China’s industrial companies are trading at a 38% higher premium than those in the United States and consumer goods companies enjoy a 58% advantage.
To justify current prices, Chinese companies need to cut their operating costs, according to David Cogman, a partner in McKinsey’s Shanghai office, and Emma Wang, a partner in Hong Kong. “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,” they write in “Can Chinese companies live up to investor expectations?,” in the May issue of the McKinsey Quarterly. American companies, in fact, have consistently brought higher returns on capital.
Chinese managers will need to be more thoughtful about how they use capital, which won’t be easy, Cogman and Wang argue, because capital is freely available. The Chinese government is aware of the problem, however. If it succeeds in creating more active bond and equity markets within China, these may push managers to be more disciplined and reward investors with earnings growth.