The China market is so hot it is burning the hair off the backs of Shanghai pigs. We’re talking sizzling.
A colleague recently told me his friends in Shanghai stayed home during the May Chinese national holiday week to read up about investing in the stock market. Chinese investors are opening brokerage accounts at a rate of 300,000 per day. Locals believe it is easier to make money in the stock market than by working.
The benchmark Shanghai-Shenzhen A-share index (known as the CSI 300) gained 127% in 2006 and is up a whopping 74% so far this year. The average P/E of A-share Chinese stocks now exceeds 40, which should put to rest any hope of making a reasonable valuation argument.
This has all the earmarks of a classic bubble fueled by unsophisticated newbies.
The problem is that the China A-share market is effectively closed to foreign investors, and conversely foreign markets are closed to mainland Chinese. Furthermore, only a fraction of outstanding A-shares actually trade in the marketplace due to big stakes still owned by government agencies. In short, the local stock market is the only place for Chinese to invest, there is a limited supply of shares, and short opportunities by foreign investors are very limited. This helps to explain why the A-share market is so much more susceptible to volatile supply and demand swings.
For international investors, there are better ways to play China . For example, our China portfolio has no exposure to A-shares whatsoever. Many higher quality Chinese companies list their shares in Hong Kong as H-shares, where investors from around the world may buy or sell.
Even though Hong Kong has been part of China since 1997, the “one-county, two-systems” policy has led to two different jurisdictions. Notably, the average P/E for Hong Kong shares is about half that of A-shares, sometimes even for shares of the same company. Returns for H-shares have also been very good, but nowhere near the speculative excesses of Shanghai . H-share returns have been more reflective of the exceptional economic growth occurring in China , coupled with some multiple expansion.
The Shanghai A-share and Hong Kong H-share markets trade with far lower correlation than one would expect for two markets focused on the same country. Indeed, shares in some companies are listed on both the A-share and H-share markets, yet the two classes of shares do not necessarily trade in tandem, even though the underlying assets may be the same. Consider the IPO of China CITIC Bank. The bank did a simultaneous dual IPO -- in Hong Kong with H-shares and in Shanghai with A-shares. The H-shares rose 14% on the first day while the A-shares nearly doubled.
In a closed market without arbitrage opportunity and foreign investors, basic supply and demand imbalances drive prices, and can lead to deviation from fundamentals and irrational speculative bubbles. Invariably, this gap will be closed. The Chinese government itself is taking measures to pop it. Recently, the government announced that it will allow local Chinese to invest in Hong Kong shares (although only to a limited degree), which should spark an H-share/A-share arbitrage opportunity.
It is entirely possible that the speculative bubble in the A-share market will continue for some time before austerity measures take effect, but let’s make no bones about it: The A-share market is likely overvalued absolutely, and absolutely overvalued compared to H-shares. Unfortunately, there are very limited ways to profit from this anomaly. The best bet would be to sell short a closed-end A-share fund, yet many of those funds already trade at a discount to their net asset values.
For example, the Morgan Stanley China A-Share Fund (nyse: CAF) is already trading at a 24.9% discount to its NAV, suggesting investors are already pricing in a significant A-share decline. I would recommend shorting the fund if the discount narrowed to less than 15% and the NAV had not moved down by more than 10%.
The bigger question with China : What may be the side effects of the inevitable “pop?” As a reminder, consider what happened when the A-shares "corrected" on February 27. The Shanghai stock market plunged 9%, igniting a global sell-off which resulted in a 41- point drop in the Dow Jones Industrial Average.
While the volatility in China isn’t all that surprising, the degree to which the dip hit global markets was shocking. The A-share market is a closed, illiquid, quasi-irrelevant market that brought down markets all over the world. We believe a reason for the decline is a lack of international understanding of how small, volatile and illiquid the floated A-share China market really is.
Over the long term, I’m very bullish on China , probably more so than anywhere in the world. But this A-share issue is not going to fade away and the risk of a corrective spillover to Hong Kong ’s H-shares or even U.S. companies is above average. With U.S. equity valuations still at very reasonable levels, we believe a material global correction catalyzed by a decline in China ’s A-share market would present a significant buying opportunity in the U.S.
Jim Oberweis, CFA, is president of Oberweis Asset Management in Lisle, Ill., and manager of the Oberweis China Opportunities (OBCHX) mutual fund. Click here for more investing ideas and analysis in the Oberweis Report.
Courtesy of Forbes Newsletters
A colleague recently told me his friends in Shanghai stayed home during the May Chinese national holiday week to read up about investing in the stock market. Chinese investors are opening brokerage accounts at a rate of 300,000 per day. Locals believe it is easier to make money in the stock market than by working.
The benchmark Shanghai-Shenzhen A-share index (known as the CSI 300) gained 127% in 2006 and is up a whopping 74% so far this year. The average P/E of A-share Chinese stocks now exceeds 40, which should put to rest any hope of making a reasonable valuation argument.
This has all the earmarks of a classic bubble fueled by unsophisticated newbies.
The problem is that the China A-share market is effectively closed to foreign investors, and conversely foreign markets are closed to mainland Chinese. Furthermore, only a fraction of outstanding A-shares actually trade in the marketplace due to big stakes still owned by government agencies. In short, the local stock market is the only place for Chinese to invest, there is a limited supply of shares, and short opportunities by foreign investors are very limited. This helps to explain why the A-share market is so much more susceptible to volatile supply and demand swings.
For international investors, there are better ways to play China . For example, our China portfolio has no exposure to A-shares whatsoever. Many higher quality Chinese companies list their shares in Hong Kong as H-shares, where investors from around the world may buy or sell.
Even though Hong Kong has been part of China since 1997, the “one-county, two-systems” policy has led to two different jurisdictions. Notably, the average P/E for Hong Kong shares is about half that of A-shares, sometimes even for shares of the same company. Returns for H-shares have also been very good, but nowhere near the speculative excesses of Shanghai . H-share returns have been more reflective of the exceptional economic growth occurring in China , coupled with some multiple expansion.
The Shanghai A-share and Hong Kong H-share markets trade with far lower correlation than one would expect for two markets focused on the same country. Indeed, shares in some companies are listed on both the A-share and H-share markets, yet the two classes of shares do not necessarily trade in tandem, even though the underlying assets may be the same. Consider the IPO of China CITIC Bank. The bank did a simultaneous dual IPO -- in Hong Kong with H-shares and in Shanghai with A-shares. The H-shares rose 14% on the first day while the A-shares nearly doubled.
In a closed market without arbitrage opportunity and foreign investors, basic supply and demand imbalances drive prices, and can lead to deviation from fundamentals and irrational speculative bubbles. Invariably, this gap will be closed. The Chinese government itself is taking measures to pop it. Recently, the government announced that it will allow local Chinese to invest in Hong Kong shares (although only to a limited degree), which should spark an H-share/A-share arbitrage opportunity.
It is entirely possible that the speculative bubble in the A-share market will continue for some time before austerity measures take effect, but let’s make no bones about it: The A-share market is likely overvalued absolutely, and absolutely overvalued compared to H-shares. Unfortunately, there are very limited ways to profit from this anomaly. The best bet would be to sell short a closed-end A-share fund, yet many of those funds already trade at a discount to their net asset values.
For example, the Morgan Stanley China A-Share Fund (nyse: CAF) is already trading at a 24.9% discount to its NAV, suggesting investors are already pricing in a significant A-share decline. I would recommend shorting the fund if the discount narrowed to less than 15% and the NAV had not moved down by more than 10%.
The bigger question with China : What may be the side effects of the inevitable “pop?” As a reminder, consider what happened when the A-shares "corrected" on February 27. The Shanghai stock market plunged 9%, igniting a global sell-off which resulted in a 41- point drop in the Dow Jones Industrial Average.
While the volatility in China isn’t all that surprising, the degree to which the dip hit global markets was shocking. The A-share market is a closed, illiquid, quasi-irrelevant market that brought down markets all over the world. We believe a reason for the decline is a lack of international understanding of how small, volatile and illiquid the floated A-share China market really is.
Over the long term, I’m very bullish on China , probably more so than anywhere in the world. But this A-share issue is not going to fade away and the risk of a corrective spillover to Hong Kong ’s H-shares or even U.S. companies is above average. With U.S. equity valuations still at very reasonable levels, we believe a material global correction catalyzed by a decline in China ’s A-share market would present a significant buying opportunity in the U.S.
Jim Oberweis, CFA, is president of Oberweis Asset Management in Lisle, Ill., and manager of the Oberweis China Opportunities (OBCHX) mutual fund. Click here for more investing ideas and analysis in the Oberweis Report.
Courtesy of Forbes Newsletters
