Chinese New Year

The Chinese economy remains a mystery in many ways and the equity market, in its many guises, is relatively cheap but very much unloved. So, as we begin the Year of the Sheep, is 2015 the year to follow, or go against the herd?

First a layman's guide to Chinese shares:

Chinese companies can have their shares listed in a number of ways:

• A shares
• B shares
• H shares
• Or on foreign exchanges, such as the US or Singapore.

Looking at H shares first, the universe is quite small: there are currently just 197* H share listed companies. They are denominated in Hong Kong dollars (the currency is pegged to the US dollar) and are mainly available to non-Chinese investors.  

Even smaller is the Chinese B share market, which is available to both domestic and international investors. This has only 100 listed securities, with a total market cap of $27bn. These shares are dying out and will probably not exist for much longer.

There is a greater choice of companies with A shares  - more than 2,500 in fact, with a market capitalisation of $5.3 trillion, which accounts for around 10% of global equity markets. However, these shares are mainly available to Chinese domestic retail investors. They are denominated in the Chinese currency, the Renminbi, and listed in Shanghai or Shenzhen.

Demand/supply imbalance

A shares typically trade at a premium to H shares, because domestic Chinese investors are unable to invest overseas. This creates a demand/supply imbalance and there is currently no easy way to arbitrage this difference.

Existing investors in the A share market often exhibit a herd mentality, so good and bad companies tend to move in the same direction. Share prices can shoot well over, or under, their intrinsic value.

The A share market is slowly opening up to international investors. As soon as the currency becomes fully convertible, these companies will become a not insignificant portion of the MSCI World Index. At face value, this suggests a lot of opportunities coming to the fore.

Beware wolves in sheep's clothing

While the opening up of the A share market greatly increases the choice for international investors, availability of these shares is currently limited for a very good reason. There is already excessive demand because Chinese domestic investors cannot invest abroad and, as the Chinese middle class is growing, this demand will continue to increase over time.

Other potential avenues for Chinese savings are also facing a clamp down. The near-default of two trust company products at the start of 2014 has lessened their attraction and the government is trying to cool an overheated property market, by imposing new regulations and minimum deposit requirements for second homes.

When considered in this context, the huge recent rise in the A share market makes perfect sense and, unless domestic Chinese investors are given other options, there is the potential for a huge bubble to form in the A share stock market.

Long-term potential

That said, the management of the Middle Kingdom has played a pretty good hand at their version of capitalism and, despite a slowing economy, China remains the main driver, in terms of GDP, of global growth. No one is quite sure what the number for that series really is, but China is definitely growing and, with a burgeoning middle class, I'm confident they will eventually succeed in reducing their reliance on exports over time.

Investors will need to tread extremely cautiously when investing in the A share market. The market is limited to international investors for good reason. There is already excessive demand in the market because Chinese domestic investors cannot invest abroad. The Chinese middle classes make up just 10% of the current population and this will only continue to grow.

So there is limited supply, already excessive demand and demand is likely to continue to grow for A shares both from a growing domestic middle class and as outside investors are increasingly allowed to invest in the market.

The Chinese government has also been clamping down on other potential avenues for Chinese savings. They are now trying to control the lightly regulated shadow credit products. Trust company products remain popular but the intensive media coverage of the near default of two of these products at the start of last year has lessened their attraction. At the same time the government is limiting property investments by imposing new regulations and minimum deposit levels for second homes. When considered in this context, the huge recent rise in the A share market makes perfect sense.

Unless domestic Chinese investors are given other options, there is the potential for a huge bubble to form in the A share stock market. Especially when you consider the market's disregard for fundamentals and herd-like mentality.

As the market opens up, the opportunity may be more in the H share market as these companies' shares rise to match their A share comparables. We might also consider the potential impact hundreds of millions of Chinese investors might have on the rest of the world, were they ever allowed to buy international stocks in the future.

Over the long term, I am a fan of the asset class. I think it will be volatile but rewarding. For those like-minded people, willing to invest against the herd, the FundCalibre Elite Rated Invesco Perpetual Hong Kong and China fund, which is also in our Core Selection, might be worth a look.

*Source: https://www.hkex.com.hk/eng/stat/smstat/chidimen/cd_hmb.htm 11th February 2015