Well, that was quick. Despite the bleak global economic outlook and the continued uncertainty brought on by the coronavirus pandemic, as of the end of August 2020, the Chinese stock market recovered to its pre-pandemic high.
Morningstar Canada’s director of investment research Ian Tam used the concept of the “pain index” coined by Dr. Paul Kaplan and showed that the COVID-19 bear market goes down in history as one of the least painful on record, lasting a total of about 120 trading days.
However, it is to be noted that the Hong Kong market has not yet recovered.
Stars
Despite the recovery, there are still some stocks in our coverage universe in China that are undervalued. We have presented three here. These stocks all have a Morningstar Star Rating of four stars. The star rating is determined by three factors: a stock's current price, Morningstar's estimate of the stock's fair value, and the uncertainty rating of the fair value. The bigger the discount, the higher the star rating. Four- and 5-star ratings mean the stock is undervalued, while a 3-star rating means it's fairly valued, and 1- and 2-star stocks are overvalued.
Moats
Two of these three stocks have a ‘Narrow’ economic moat. The Morningstar Economic Moat Rating represents a company's sustainable competitive advantage. A company with an economic moat can fend off competition and earn high returns on capital for many years to come.
Morningstar has identified five sources of ‘moat’:
-Switching costs are those obstacles that keep customers from changing from one product to another.
-The network effect occurs when the value of a good or service increases for both new and existing users as more people use that good or service.
-Intangible assets are things such as patents, government licenses, and brand identity that keep competitors at bay.
-A company with a cost advantage can produce goods or services at a lower cost, allowing them to undercut their competitors or achieve higher profitability.
-Efficient scale benefits companies operating in a market that only supports one or a few competitors, limiting rivalry.
A company whose competitive advantages we expect to last more than 20 years has a wide moat; one that can fend off their rivals for 10 years has a narrow moat; while a firm with either no advantage or one that we think will quickly dissipate has no moat. All three stocks have a ‘Stable’ moat trend. Finally, it pays to remember that these stocks have high or medium fair value uncertainty.
With these details out of the way, let’s look at the stocks.
| Name | Morningstar Star Rating | Economic Moat | Moat Trend | Fair Value Uncertainty |
| Daqin Railway Co Ltd | 4 | Narrow | Stable | High |
| Zhengzhou Yutong Bus Co Ltd | 4 | Narrow | Stable | Medium |
| Guangshen Railway Co Ltd | 4 | None | Stable | High |
Morningstar Direct Data as of September 23
Daqin Railway
The first stock on the list is Daqin Railway. Daqin is one of the few net profitable rail operators within China’s national railway system and has long benefited from China’s coal-transport bottleneck. Its core asset, the Daqin Line, is China’s premier and busiest “west-east coal rail corridor,” connecting China’s coal capital Datong in Shanxi to Qinhuangdao Port. Morningstar analyst Jennifer Song believes Daqin’s strategic location with access to Qinhuangdao Port, which is important as the barometer of China’s coal demand and prices, leads to a virtual monopoly, and this, along with Daqin’s cost advantage and high operating efficiency, should help the company to defend its leading position in coal rail transportation.
“We think Daqin is undervalued presently, trading at 0.8 times price/book, which is lower than the company’s 10-year average of 1.6 times and our valuation of 1.1 times price/book. We believe the discount reflects some market concerns over both short-term demand shortfall, and long-term threats amid China’s shift toward a more service-based economy and greener energy mix, as well as rising competition following the start of the Haoji Line that connects Inner Mongolia directly to central and south China through railways. Despite these challenges, we think China’s stricter air-pollution controls will see rail transport replacing coal trucks and drive robust coal rail-transport volume in the longer term. In addition, Daqin Line’s competitiveness in cost advantage remains unchanged,” Song says.
She notes that the company’s narrow economic moat rating is derived from cost advantage and an efficient scale. Her fair value estimate for Daqin is CNY 8.40 per share, which implies a price/book multiple of 1.1 times, below the company’s recent 10-year average.
Zhengzhou Yutong Bus
Narrow-moat Yutong started manufacturing buses in the 1960s and has since established a solid reputation for rolling out high-quality products to meet the ever-evolving market demand. Its dominant position in buses is evidenced by a leading 35% market share in China. With over 1,700 servicing locations in China, Yutong has the broadest servicing network in the industry, comparing favourably with King Long’s 1,300, Zhong Tong’s 500, and Yaxing’s 400 locations.
More than 10% of Yutong’s bus sales come from overseas, namely Southeast Asia, Latin America, and Africa. Chinese buses thrive in these markets because of their cost-efficient nature. Furthermore, China’s belt and road initiatives should help Yutong to expand deeper into other rapidly developing parts of the world.
Morningstar analyst Ivan Su points out that “A coronavirus-induced 34% decline in sales volume resulted in a significant drop in the business’ revenue during the quarter. Fixed cost deleverage on lower sales further drove down profitability, and the compression was more than our previous expectation. We cut our 2020 forecast but maintain our CNY 17.70 fair value estimate for Yutong as our long-term forecast remains intact.”
He expects the group’s working capital base to decrease as subsidies decline over the next few years. He has also factored in lower margins and slower sales growth as subsidies in green buses fade.
Guangshen Railway
Guangshen Railway is one of the key railway operators in Southern China's prosperous Guangdong province. With key assets situated in the Pearl River Delta, Guangshen's operations comprise both passenger and freight and connect southern China's three largest population centres: Guangzhou, Shenzhen, and Hong Kong. Its favourable geographic location and high-quality railway assets are key strengths. While rising competition from high-speed rail poses a threat to Guangshen's profitability and competitive strength, Song thinks the company will benefit from ongoing railway sector reform, which should offset some of that negative impact.
She does not believe Guangshen possesses an economic moat, as rising competition from high-speed railways and China’s centralized pricing framework have historically led Guangshen to earn returns below its cost of capital. “We believe this situation will extend into the foreseeable future, preventing the firm from digging an economic moat,” Song says, pegging the stock’s fair value at CNY 3.74 per share, which implies a forward fiscal-year price/book multiple of 0.9 times and is higher than its 10-year average of 0.8 times, reflecting potential earnings upside from ongoing railway reforms, the company's net cash position, and possible land revaluation gains.
