Earnings illusion threatens Chinese market: Wei Gu

(Wei Gu is a Reuters columnist. The opinions expressed are her own)

By Wei Gu

HONG KONG (Reuters) - This is one of those columns that predicts a bitter end to China's stock market party.

Stop reading now if you're tired of those "what-goes-up-must-come-down" sirens that the Shanghai Composite Index has blithely ignored, having quintupled in just two years.

But the logic for a precipitous fall is just the same as the logic that has driven the market ever-skyward, except in reverse.

Much of the stellar growth in Chinese corporate earnings has been generated by the rise in stock values because many companies have invested heavily in the market rather than core businesses.

It's a virtuous circle: if the market goes up, earnings go up, and if earnings go up, the market goes up. Neat. Now replace the word "up" with "down".

A consolidation of Chinese stocks would be like a snowball building on itself. Even a mild fall in the broad market would trigger a huge earnings shortfall for some firms whose earnings are top-heavy with investment returns.

Unfortunately, the average investor does not appear to be fully discounting this possibility right now.

"The snake is eating itself," says Jerry Lou, Morgan Stanley's China strategist. "Any potential negative news could blow up the largest equity bubble we have today."

Many analysts argue that it's hard to be bearish when the average growth in corporate earnings is a staggering 70 percent.

But after adjusting for investment gains, average profit growth for the first nine months of this year drops to 41 percent, according to calculations by HSBC bank. Put another way, price-earnings ratios based on core earnings would be double what the market sees now.

Worse, the problem is becoming more pronounced.

Investment income for all non-financial companies listed in China has more than tripled from a year ago. HSBC found that after stripping investment income out, about 130 companies would have sunk into the red in the third quarter.

REMEMBERING JAPAN

So where will the falls be hardest?

Consumer and healthcare companies are likely to feel the most pain on the downside. They almost doubled net earnings in the third quarter, but their core earnings actually fell 20 percent and 7 percent, respectively. Now both sectors trade at above 100 times forward core earnings, while energy firms, telecommunications companies and banks are trading below 40 times.

Banks' earnings have also ridden on the stock market, and so they might be vulnerable too. Much of the Chinese banks' robust fee income growth has come from distributing mutual funds and selling equity-related products. Meanwhile, two-thirds of brokerage industry profit has derived from highly volatile commission income that is subject to swings in the market mood.

To make matters worse, a new accounting rule is also inflating earnings. China now allows companies to mark certain assets on their books at their present market value, in line with the international standard. The rule is supposed to be applied prudently, but many Chinese companies treat 'mark to market' as a tantalizingly easy way to boost profit.

Those with a memory of not-too-distant times will recall that widespread cross-shareholdings were a big factor when the bubble burst in Japan.

At the market peak in 1989, Japanese companies traded at price-to-earnings levels of about 40 to 50, similar to where China stocks are now. After the crash, even after the companies had lost about a third of their stock value, the PE ratios soared to about 70 -- a result of inflated "earnings" evaporating.

So what can investors expect from regulators? China's market watchdogs are clearly aware of the problem.

Qi Bin, head of research at the China Securities Regulatory Commission, said recently that the commission urges companies "to stay in their main business", without providing further details about how that prescription might be encouraged or enforced.

But if that reflects the extent of the government's preparation for a market downturn, Beijing, too, may be in for a shock. The broad market has fallen 18 percent from its October peak, and the trigger for the unwinding cycle may already have been pulled. (At the time of publication Wei Gu did not own any direct investments in securities mentioned in this article. She may be an owner indirectly as an investor in a fund)