US stock premium is shrinking

The pending takeover of IBM's computer manufacturing business by the mainland's largest PC maker Lenovo is an important sign of things to come. Not only does the US$1.25 billion deal point to a promising consolidation of the industry, it indicates the vigour of the Asian region as venture capital flows out of the United States in search of high-growth companies for the first time since the dotcom collapse. California-based chief executive of the venture-capital consulting firm Williams Capital Advisors, David Williams, says Asia has been back on the map ever since the initial public offering of mainland online travel firm Ctrip about a year ago. Upon its Nasdaq debut, the first by a mainland firm since the tech bust, the share price doubled. 'It was the first doubler in years on Nasdaq and, boy, did that open eyes,' Mr Williams says. Ctrip was a leader in its field in the same vein as Google, Yahoo! and eBay, and investors were willing to write off the emerging market discount to get a slice of the 'category killer'. Now trading at about 40 times earnings and a market cap of US$1.27 billion, Ctrip trades at a premium to its direct US comparables - Orbitz, Expedia and Priceline. Investors are willing to pay more for Ctrip because they believe it will be able to leverage its substantial lead in online travel bookings to ward off competitors. The shrinking premium between US stock and emerging markets is not just limited to technology. Since 1995 the spread between the price earnings multiple for the S&P 500 versus the H-share index has dropped from 25 to 16. 'And that's because China has become much more stable,' Mr Williams says. 'As the years go on, I would wager that multiple will keep going down.' Another trend taking shape is a rise in the premium investors are willing to pay for fast-growing companies. Back in 1995, the technology-laden Nasdaq commanded a 17-point premium to the S&P 500. Today that premium has risen to 34 points. He says the increased appetite for risk is due largely to low interest rates and abundant worldwide liquidity. 'When interest rates drop as much as they have, investors are willing to pay more for earnings and growth,' he says. 'If those earnings double every year, the discounted cash flow effect is multiplied.' That means Chinese companies, with better long-term growth prospects, could soon be valued equal, or even at a premium to US counterparts - an idea which the smart money is already taking to heart, he says. Ctrip is a case in point. With a long-term earnings growth rate of 40 per cent, on paper the company looks similar to eBay or Amazon, with respective growth rates of 35 and 25 per cent. In the big picture, China's booming economy and larger population mean there is a long way to go before Ctrip is anywhere near saturating the market. 'The higher growth offsets the now diminished risk premium,' Mr Williams says. 'The trend will get stronger as China industrialises.' If his theory is correct and the trend continues, the implications are big. The Morgan Stanley Capital Index - a benchmark used by fund managers to determine equity allocation by region - currently gives Asia ex-Japan a 5 per cent weighting. This means a typical fund manager operating a global fund would allocate about 5 per cent of the fund's holdings to the Asian region - a number that appears woefully out of date if Asian firms are rerated higher. Investment banks such as Baring Asset Management have said the rerating is a matter of when and not if, suggesting the MSCI will be rebalanced with a 30 per cent allocation to Asia ex Japan within a decade. Mr Williams says the trend is occurring across many sectors and markets in Asia, most visibly in the technology sector, especially among dotcoms where the earnings multiples are higher. 'Investor interest is concentrated in tech, but this dynamic is showing itself everywhere,' he says. He says his theory has been generally well received among the financial community. A former head of the emerging markets internet group for Merrill Lynch in Hong Kong during the late 1990s, Mr Williams says he is more optimistic about the quality of the companies coming to market. Instead of buying into stocks which are little more than concept stocks, the market is much more rigorous than during the bubble days, and more diligent in separating out the hype. 'You are going to see more careful selection of IPOs by investors,' he says, referring to Nasdaq-listed plays. 'You ought to see more discrimination by investors, more homework and more differential between the number twos and threes.' In pace with the more reasoned approach, he says, American venture capitalists are increasingly turning to India where valuations are cheaper. Many analysts are turning on to the subcontinent because it is much earlier in the growth cycle, and has so far been left out of the media glare as Beijing has dominated centre stage. 'India is where China was in 1999,' he says referring to country's internet and mobile-phone penetration rates. About 20 per cent of the mainland population use the Internet, compared with only 5 per cent in India, according to year-old data. He says India's annual GDP growth is rapidly closing the gap with the mainland, despite foreign direct investment of only US$3.4 billion in 2003, compared with US$53.5 billion in China.