More Than Two-Third of China Stocks Are Cheap

Stocks in the Hong Kong/China markets ended the year with at a 17% discount. In the new year, Chinese stocks further cheapened, ending Jun 16 with a 19% discount.

Between January and mid-June, energy was the only sector that enjoyed a positive return, gaining 16.3% on the back of rising oil prices. The strong year-to-date performance brought the sector to overvaluation on average. The sector started 2022 with a 14% undervaluation and stood at fair valuation now. Another sector that turned more expensive against their fair value estimates was real estate, despite a year-to-date loss of 13.7%.

Except for the energy and real estate sectors, valuations of the remaining groups were trending down through mid-June. The deepest discount by sector came from basic materials.

But Now, Opportunities Abound

The broad market’s valuation has been down, which in turn offers investors a larger opportunity set of cheap stocks to consider.

One way to find such opportunities is the Morningstar Star Rating. A company with 1 star is expensive, 3 stars is fairly priced, and 5 stars is undervalued. The star rating incorporates a level of uncertainty in the estimates. What this means is that even if two companies have very similar price/fair value ratios, it doesn't necessarily translate into the same Morningstar rating.

In the graph below, we compare the number of stocks that earn a Morningstar Star Rating of 4 and 5 stars (companies considered a buy – in green) and the number of stocks with 1 or 2 stars (could be considered a sell – in red).

Cheaply-priced stocks (under our coverage) have outnumbered the overvalued names in the past three years. The gap between the two widened further in recent months. The correction at the time of the initial wave of the COVID outbreak has been a yardstick for market participants to gauge a downdraft or a recovery that could follow. By the end of March 2020, 65% of our coverage was ranked 4 or 5 stars.

At the end of May 2022, 70% of our coverage of Hong Kong/China stocks are undervalued, coming down slightly from April’s peak of 71%. Still, the level is well above the 40% range from a year back.

New 5- and 1-Star Stocks

Heavy swings in share prices in the second quarter put five new companies in the 5-star rating camp.

AAC Technologies (02018), which was removed from Hang Seng Index in the latest constituent review, is trading at the deepest discount of 42% against its fair value estimate among the five stocks. Moreover, our analyst Phelix Lee believes that recovery for AAC is around the corner. “We expect demand for smartphone upgrades to recover and supply constraints to alleviate in 2023. Our long-term margin expansion story for AAC Technologies driven by the lens upgrades and utilization improvement is intact,” Lee notes, thus assigning it a 5-star rating.

Among all covered Chinese e-commerce names, JD.com (09618) remains our top pick, which is trading at a 40% discount. Morningstar’s senior equity analyst Chelsey Tam believes JD.com is well-equipped for a longer runway than its peers, thanks to its self-built logistics network that sprawls across China.

The A-share listing of Anhui Conch Cement Co Ltd (600585) and Ping An Insurance (Group) Co. of China Ltd (601318) trade more than 30% discount to fair value.

Four stocks are rated one-star, and two are new entries to the list. They are Sunac China (01918) and the A-share listing of Tsingtao Brewery (600600).

While trading in its shares remains suspended, Sunac China’s fair value estimate was slashed by 97% in mid-May after missing its USD bond coupon payment. The firm warned investors that it could miss more deadlines for its outstanding offshore bonds.

The A-share listing of narrow-moat Tsingtao Brewery is priced 58% above its fair value estimate. Though, their Hong Kong-listed share class trades at a less stretched valuation. Share price in the beer maker was under pressure as COVID-19 lockdowns weighed on beer demand and logistics.