We are bullish on mainland Chinese and Hong Kong stocks. The Shanghai stock market is going up, and there are several theories about why it is rising. Our favorite is that when the U.S. grows more slowly, money migrates to China. In our opinion, something like that is also happening to Hong Kong companies -- the Hang Seng Index is the Hong Kong stock market index.
There are three ways for westerners to invest in China.
1. You can own Chinese companies listed or traded on U.S. exchanges. Alibaba (BABA) is one Chinese stock owned by many U.S. investors. We do not own it due to an investigation by the Chinese government of the quality of products that individual shop owners sell online through Alibaba. The Chinese government suspects fraud from a percentage of sellers.
2. You can own the biggest Chinese state-owned companies (usually called H-shares or the Hang Seng China Enterprises Index) that trade in Hong Kong; there are some private companies in this group as well. Foreign investors remain almost entirely shut out of directly investing in China, except by buying H-shares in Hong Kong. We own some H-shares and H-share ETFs that trade in Hong Kong for clients and for ourselves.
3. You can buy U.S.-traded ETFs that attempt to track the Shanghai A-share market. A-shares are Shanghai stocks bought by Chinese investors. Chinese investors are very short term traders. They hear stocks touted through the rumor mill, and buy for pure speculation. They like to test their luck. We own such an ETF for clients and our own accounts -- the Deutsche X-tracker Harvest CSI 300 (ASHR) , which invests in the 300 biggest stocks listed in Shanghai. There are also ETFs of the Shenzhen A-share market -- which is heavier in speculative small-cap stocks, many of them tech-related.
However, explaining to westerners why Chinese investors are buying stocks is more difficult. Chinese stock-market logic is not like western (U.S., European, and Latin American) investor logic.
Westerners buy stocks for fundamental reasons, such as:
- The company is growing, and low-priced versus its growth rate;
- The company is valuable, with big assets underlying a low stock price;
- The company has a track record of rising dividends;
- The company is growing its business and getting new contracts; or
- The industry that the company is in is enjoying macroeconomic tailwinds or being favored in new legislation.
Chinese investors, on the other hand, buy stocks mainly because they think the government is support- ing that activity. For years, Chinese investors believed that the government was supporting real estate, so they bought second and third homes. Now Chinese investors think the government wants the real estate bubble to deflate and stocks to rise -- so they are buying stocks.
One attractive thing about Chinese stocks from a western investor’s point of view is that Chinese stocks are cheap, and all experienced international investors know that they can get expensive -- as they have on several occasions in the past 20 years.
That is just beginning to happen in China, where profits have grown rapidly for years and are now growing more slowly, although they are rising.
Here are a few of the regulatory and market events and trends that Chinese investors are seeing as positive signs:
- The Shanghai-Hong Kong Stock Connect. As we describe below, this is a new trading conduit where mainland Chinese investors can buy many stocks listed in Hong Kong (so-called southbound trading), and foreigners can buy Shanghai-listed A-shares through Hong Kong brokers (so-called northbound trading). Both southbound and northbound trading have daily quotas, and trading is halted if those quotas are reached.
- Mainland mutual fund access to H-shares. Initially, southbound trading was limited to wealthy investors (those who could afford to put about $80,000 in a brokerage account). On March 27, however, the government announced that they would allow mainland mutual funds to buy H-shares -- mutual funds which mainland investors can buy even without the minimum account balance necessary to buy thoseH-shares directly for themselves. This has revitalized the southbound trading traffic, as mainland inves- tors of smaller means seek to buy the equivalent of Shanghai-traded big companies that also trade in Hong Kong at much lower prices. In other words, the A-share price (Shanghai price) of a company may be much higher than the H-share (Hong Kong) price of the same company. The southbound trading quota was hit last week for the first time since the Stock Connect launched in November, and has powered a fierce catch-up rally in H-shares.
- Declining interest rates. The government is trying to shift focus to stocks as an alternative to real estate investing. Real estate values have been falling for two years. Further, the economy is transitioning to a model in which consumption will be a much larger portion of economic activity and manufacturing will continue to fall as a percentage of total GDP. Currently China’s consumption as a percentage of GDP is about 35 to 40 percent, versus approximately 60 percent in the rest of the world.
- Hot initial public offerings (IPOs). Some new offerings are doubling or tripling within a few months after coming public.
- Brokerage clients borrowing on margin. Trading on margin has only been allowed since 2010, and was fully introduced in China in late 2011.
- A surge of new brokerage accounts being opened. With millions of new accounts, the number opened per week is currently at a new all-time high.
It is obvious that China looks like it will eventually turn into a bubble (as it has in the past), but we all know a great deal of money can be made by investing while the bubble is inflating, and getting out after you have made a good profit but before the ultimate collapse is set in motion. That summarizes our view of China -- we have been investing there for some time and we have made money, but we intend to make more. Our current allocation is about 20 percent in mainland China and about 10 percent in Hong Kong.
Investment implications: In our opinion, China is a stock market in the process of forming a smallish bubble, and one which can move higher and higher until a big bubble is created. Hong Kong is a market enjoying a tailwind from China investment, and new money from western investors is moving to Hong Kong to benefit from the Chinese stocks that trade there.
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