The China Syndrome

How to Profit from the Chinese Boom
Over the past few 2 weeks the Chinese Government has taken several steps to cool the economy.

Last week, the China Banking Regulatory Commission (“CBRC”) announced that the Qualified Domestic Institutional Investors (“QDII”) quota can be invested in HKG stocks last week (previously only in fixed income products).
This week, the CBRC raised interest rates and banks reserves at the same time.
Does this mean the end to the “Rise of the Dragon”? The answer, as always, is yes and no.

Yes
The CBRC is showing that it is taking the surge in the stock market seriously. It understands that it would take very little to tip the market over the edge and the result is mass market hysterical boom which can only end in a very painful bust.
We can expect that the CBRC will continue to try to calm the market. However, the tools available are limited.

No
The Chinese market is in the beginning stage of a boom. Forget about the years before 2005. The Chinese Government was experimenting with the stock market in the early days. A lot of rubbish were listed and this lead to several major busts and scandals resulting in loss of confidence in the market.

Starting in 2005, under the guidance of the State-owned Assets Supervision and Administration Commission (SASAC), several major state-owned enterprises (“SOE’s”) were restructured and listed in HK. The process started with the banks and insurance companies ending in 2006 with the listing of Industrial and Commercial Bank of China (ICBC #1398) which became the largest IPO in the world ever. Only the Agricultural Bank of China is left to be listed but the restructuring is expected to take until late 2008, and even then we expect that this may be the first all A-share bank IPO.

During 2006, we have seen A-shares and H-shares listed in both HK and Shanghai. This will continue as the Chinese Government is under pressure to ensure that Chinese citizens share in the “bounty”. All privatizations overseas have ensured that local citizens benefited from the rise in stock prices after the IPO, and China should not be expected to be any different.

In the 2 years, we will see more SOE’s listed on both HK and Shanghai.
Where Do We Go From Here?

The Taiwan went up 5 times in 9 months in 1986/7. It then proceeded to defy all predictions of a crash rising another 4 times before finally plunging. Will the Chinese market be a repeat of this?

The conditions are very similar indeed. Except for a very small Qualified Foreign Institutional Investors (“QFII”) quota of USD10 billion and a failed experiment with B-shares (foreign owned and denominated in foreign currency), there is no foreign participation in the market. With daily turnover exceeding USD40 billion, it is clear that the bulk of the funds invested in the market are local.

Since until recently, banks and insurance companies were banned from investing in the stock market, the bulk of the investing is retail oriented. There are over 100 million stock trading accounts with over 200,000 new accounts opening daily.
Some companies are reported to be giving staff “trading breaks” to allow them to place their orders with brokers.

Are We Set For A Bust?
By Western standards, the Chinese market is way overheated trading in excess of 40 times forward price-earning ratio (“P/E”). However, it was explained to me last week in Beijing by a local investor that Chinese citizens have no where to put their money. A rate of return of 2.5% implicit in a P/E of 40 times is still better than bank deposits, and there is no need to explain to the tax man where it came from.
China has a huge trade surplus, foreign direct investments (“FDI”) is growing rapidly, and the RMB is appreciating against the USD. The end result is a booming property and stock market.

An Arbitrage Strategy
For the same company listed in both HK and Shanghai, the A-shares in Shanghai attract a higher P/E because of the lack of supply. With the lifting of restrictions on QDII, we are already seeing more Chinese money moving into the H-shares on HK market. We expect this to continue as the QDII quota is expanded.
The Chinese Government appears to have decided that the combination of QFII and QDII can serve as an appropriate arbitrage platform between the currently highly valued A-shares and their H-shares counterparts. Thus, we will see the valuations converging with the H-shares catching up.

The Chinese banks are a relatively safe bet as they are under the supervision of the CBRC in their banking operations i.e. an additional layer of supervision. The state-owned banks are trading at a lower valuation: CCB (#939), Bank of China (#3988), and ICBC (#1398).

Return of the Red Chips
There are a number of “red chips” i.e. companies which have re-domiciled outside of China and listed in HK. The China Securities Regulatory Commission (“CSRC”) announced last week that “red chips” with more than RMB1 billion in annual earnings will be allowed to list A-shares in China.
Several names have been mentioned as possible candidates: China Mobile (#941), China National Overseas Oil Co. “CNOOC” (#883), China Netcom (#906), Citic Pacific (#267).

Companies which were listed in HK in the 3 years are exempted from the RMB1 billion profits requirement e.g. Tianjin Port (#3382) is an example.
Restructuring

We expect that there will be massive restructuring in the non-bank SOE’s over the next 4 years.

The Chinese Government is looking to build some of these companies into world class competitors through injections of assets. We have seen in the past that assets injected into SOE’s have been beneficial in terms of shares prices and do not see any reason for this not to continue.

The following should be considered prime candidates for asset injections: China Coal (#1898), China Shenhua (#1088), and China National Building Materials “CNBM” #3323.

Conclusion
You cannot afford not to be invested in Chinese shares. Take advantage of market pull-backs to accumulate and trim your portfolio when valuations appear to be getting out of hand. But invest, you must.