(Bloomberg Opinion) -- China is nothing if not ambitious. Facing a coronavirus-battered economy, Beijing is speeding up an infrastructure build-out to stimulate growth, vowing to spend an estimated $1.4 trillion over five years on areas such as 5G, industrial automation and cybersecurity.
This enthusiasm has propelled a fast and furious surge in stocks. The tech-heavy ChiNext Index is up 46% this year, and sports an eye-popping valuation of 35 times 2021 earnings. That’s above the Nasdaq Composite Index’s 27.5 times, which is already expensive and reason enough for the rally to fade.
Investors are smart to play in fields where the fiscal dollars are. But it’s also a dangerous game. What’s recurring income and what counts as extraordinary items? Once we remove government subsidies, the valuations of China’s tech darlings become even airier.
Helicopter money can come in many forms. First and foremost, Beijing is a large client. Even before the coronavirus, the government was the biggest buyer of IT security, accounting for 27% of total spending last year, according to IDC. Meanwhile, the latest policies, which require stringent security reviews, clearly favor local providers. Investors have picked up on this theme: Shenzhen-based Sangfor Technologies Inc., with a 25% and 22% market share in China’s VPN and content security segments, has soared 89% this year to $12.6 billion in market value.
There are also regular cash handouts that lubricate companies’ daily operations, and money for new industrial parks. Injecting capital outright, as well as fast-tracking public-markets financing, are also on the table. Semiconductor Manufacturing International Corp., China’s largest chip foundry and its best shot at catching up to Taiwan Semiconductor Manufacturing Co., checks all of the boxes. Its Hong Kong-listed shares have risen more than 200%, amassing a market cap of $29 billion.
Without the Beijing put, though, the income statements of many tech firms would look drastically different. At SMIC, government funding, which appears in “other operating income,” rose 87% to $293 million in 2019. A further $59 million in the first quarter exceeded the foundry’s $51 million bottom-line profit; in other words, without subsidies, SMIC would be in the red — and it wouldn’t even have a price-to-earnings ratio to look at.
This phenomenon is pervasive. Of the 37 listed companies classified as “integrated circuit” industries, subsidies accounted for a whopping 15% of operating profit last year, on a market-cap weighted basis, Bloomberg Opinion analysis shows.
The stand-outs are memory-chip maker Gigadevice Semiconductor (Beijing) Inc. and Unigroup Guoxin Microelectronics Co., which designs chips used in smart cards. A similar picture emerges for software companies, such as Yonyou Network Technology Co., which aims to become China’s Salesforce.com Inc., and Sangfor. All these stocks are big winners this year.
While it’s great Beijing is tending its tech gardens right now, the question is whether and when it will pull the plug. Over the years, China’s electric vehicle sector has had an on-again, off-again relationship with subsidies, creating turbulence in stocks, as my colleague Anjani Trivedi has written. Will the government get tired of paying for an expensive tech build-out, too?
Another aspect worth considering is that, unlike previous endeavors, this new infrastructure spree will rely more on local governments than national spending. Indeed, major areas including Beijing, Shanghai and Jiangsu province have been rolling out ambitious investment blueprints lately. But, pinched by the virus outbreak, they have no money. Their funding gap will reach as much as 11.5 trillion yuan ($1.64 trillion) this year, according to the Ministry of Finance. The southwestern city of Chongqing, for instance, saw its fiscal revenue tumble by 16.8% in the first four months this year. Still, it vowed to become a strategic investor in Tsinghua Unigroup Co., which has the very expensive goal of becoming China’s Samsung Electronics Co. Will Chongqing be able to deliver?
Of course, extraordinary times call for extraordinary ways to look at stocks. Right now, investors have big grins on their faces when they do a word search for mentions of “government” in company filings. China’s tech carnival can’t go on forever, though. At some point, wary of the trillion-dollar bills, Beijing will want to slow down the money flow. By then, investors will be left holding stocks with lofty ambitions and peanut-sized earnings.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Shuli Ren is a Bloomberg Opinion columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.
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