Wednesday, July 11, 2007
Market Excess Spillover
While I am a firm believer in the China story, the stock market gains there needs to be continually reassessed. Many bulls would cite the huge profit growth in store for many listed companies as the main pillar driving higher valuations. The above chart from WSJ is very revealing. Just look at "investment income as a percentage of net income of listed companies". Listed companies flushed with cash usually invest in other Chinese listed firms. On a sharply rising market, the "unrealised / realised gains" will be substantial. Now if 24% of a listed company's net income comes from these holdings, I'd be very worried.
The oft cited profit growth need to be adjusted for the stock market effect. Savvy investors should strip out these type of gains to get a better hold of fundamentals. Imagine a 30% crash, what will happen to the write downs affecting these so called profits.
There are normal earnings and quality earnings. Investment gains from investing in listed companies does not constitute as quality earnings. Quality earnings has to be predictable, preferably from organic growth, non-volatile and recurring.
Good analysts will strip out these gains as one-off type and not include as part of normal operational gains. You cannot assess PER and PER growth properly using these one-off gains. It would be better if the gains are realised, i.e. securities held are sold off to obtain cash. Smart companies would have a "properly outlined strategy" with regards to these type of investments. This is so that analysts and investors do not have to second-guess management's motives and objectives. A company can end up with 50% of net profit from playing the stock market, what then? If a company likes to play the market so much and think they are so good at it, they should set up a separate listed entity in fund management.