Valuations for the China's markets have soared to precarious heights over the past year. Investors should exercise caution when investing in these markets.

In 2006, both the domestic A-share markets and fund investible China market, as represented by Hang Seng Mainland Composite Index, enjoyed a spectacular run-up. The Shanghai Composite Index (SHCOMP) went up by 130.4%, while the Hang Seng Mainland China Index (HSMLCI), the proxy for the China market, was up 72.8% in local currency terms. During the first four months of 2007, the SHCOMP went up 43.6% while the HSMLCI returned only 0.9% in local currency terms. Even though the performance of the domestic market in 2007 has been also spectacular, there have been concerns that the Chinese equity markets may be overheated. Valuations of A-shares have not only become very expensive, but another worrying trend is that the majority of market participants are either individual retail investors or speculators.

Chart 1

Source: Bloomberg

We observed that thus far this year, the Chinese domestic A-shares market seemed to lead the regional equity markets during temporary global corrections in January, and more prominently, in the March to April period, despite the fact that Mainland markets are mostly closed to foreign investors. Foreign investors, including some mutual funds, have very limited access to the A-shares market, through a scheme called Qualified Foreign Investors Scheme (QFII). But the sum of the QFII quota is a mere 0.5% of the Chinese equity market capitalization of US$2 trillion, at US$10 billion. Thus, even though foreign investors including numerous mutual funds and hedge funds have strong interest in domestic A-shares, they could only take a very small stake, if any, in the A-shares market, normally through the quota issued under the QFII scheme.

Therefore, Singapore investors would normally have limited exposure to China A-shares. Nevertheless, there are certain dynamics between A-shares and those Chinese companies listed in Hong Kong and overseas which Chinese equity funds investors should be aware of.

Red-chips, A-shares and H-shares

Red-chips listings were started in the 1990's. At that time, the domestic equity markets were not popular, thus major Chinese companies went overseas for listing. Red-chips are Hong Kong or overseas listed companies where the majority of their operations and controlling shareholders are in Mainland China.

With the removal of non-tradable shares and other overhangs, mainland markets have shown a strong up run which started in late 2005. Major mainland companies are able to tap into domestic market for funds. Hence, most of these companies can also be listed on China's domestic exchanges, rather than being limited to listing on the Hong Kong exchange only. China Mobile (HK) Ltd. is a classical red-chip company that has a shell company in Hong Kong while the operations and revenue are mainly situated in and derived from the Mainland. Both A-shares and H-shares are issued by Mainland state-owned enterprises which are listed in domestic markets and Hong Kong stock exchange respectively. The four major domestic banks are listed in both the Shanghai stock exchange and the Hong Kong stock exchange.

Same companies listed as A-shares and H-shares

One of the dynamics between A-shares and H-shares is that some of the largest cap companies are listed in both the A-shares and H-shares markets. Among the top 20 members of the Hang Seng Mainland Composite Index, 6 of them are shares of the same companies listed in the domestic A-shares market, as seen in table 1, while the others are termed Red chips or Hong Kong companies with China plays. Since A-shares and the H-shares of the same companies are not directly fungible or interchangeable, A-shares and H-shares of the same companies could be traded at different prices for the same underlying earnings.

Table 1: Top 20 Weightings (%) in Hang Seng Mainland Index as at May 10, 2007

Source: Bloomberg

Thus, valuations would be different, given that A-shares are generally trading at a premium to its H-shares counterparts. Demand and supply plays a critical role in explaining the difference. Domestic retail investors in China divert their savings from their bank savings accounts - which give negative real interest (which means that interest rate net of inflation is negative) - to the stock markets based on sentiment, rather than fundamental analysis. With property markets cooling down slightly as more macro measures have been taking place and the relatively under-developed domestic bond markets, domestic investors are left with little choice in investment instruments. Hence, equities listed in stock markets are their obvious choice.

Other factors such as capital flow restrictions, interest rates, financial market structure, market speculation, also contribute to the differences in valuations between the two markets. We can get an indication of the retail investor sentiment to the market from individual stock performances and account opening statistics. According to official figures, 10 million new trading accounts were opened in the past four months in 2007, more than the total number in the past 5 years. Another example is the stock performance of China Citic Bank, listed on 26 April 2007. Its H-shares went up 14% after one day of listing, while its A-shares shot up by 96% in local currency terms.

Valuations are expensive for A-shares

With retail investor sentiment at an all-time high, the SHCOMP hit a new historical high, crossing over 4,000 points on 4 May 2007. In terms of trailing Price-to-Earnings Ratio (P/E), it is trading at 41.2X (according to Bloomberg) which is also a historical high, as seen in Chart 2.

In fact some companies within the constituents of the index are trading at over 100X P/E. What this means is investors are willing to pay 100 folds of the earnings per share that a company has made in the preceding year, hoping the company share price could soar further. Compared with a 4-year average P/E of 28.7X, the A-share market P/E is on the high side. For forward P/E, which is based on estimated future company earnings, the SHCOMP was trading at 36.2X P/E as of end April 2007, way above the 4-year average.

Investor sentiment has been heating up, and investors seem to be ignoring the market fundamentals, simply buying stocks in the belief they could rise further. They also ignored warnings from government officials, including the governor of the People's Bank of China, that the market may be due for a drastic correction.

Chart 2

Source: Bloomberg

HSMLCI: Valuations are moderate in comparison

Compared with the A-shares SHCOMP index, the HSMLCI is trading at a more moderate P/E. The earnings announcement in March to April 2007 was supportive, reducing the P/E from over 21X in January 2007 to the current level of around 15X P/E. Compared with a 3-year historical average of 14.5X, the current P/E as of end April is close to the average. Chart 3 shows that the P/E for the HSMLCI is at more reasonable levels in comparison to that of the A-shares. With more moderate valuations, the HSMLCI index is less likely to be as volatile as the domestic A-shares market in the near future.

Chart 3

Source: Bloomberg

QDII expansion supportive to H-shares

Following the China Banking Regulatory Commission's latest announcement on May 11, the Qualified Domestic Institutional Investors (QDII) scheme has been further revised. It is believed as one of the means to vent off the pressure of the heated A-shares. The revised scheme allows commercial banks to issue investment products or invest which invest up to 50 percent of the net value of their offshore investment in stocks. The China Banking Regulatory Commission (CSRC) gave the official go-ahead to allow commercial banks on the mainland that hold qualified domestic institutional investor (QDII) quota to issue wealth management products that invest in overseas stocks.

Since the revised QDII scheme allows commercial banks to issue products that may invest into Hong Kong listed stocks, and Hong Kong authorized mutual funds, H-shares and red chips listed in Hong Kong would benefit from these investment inflows. The estimated outflow to Hong Kong shares is estimated to be in the region of US$7bn to US$10bn for the next 12 months. Experienced investors who have at least 300,000 yuan may be eligible to buy financial products under the scheme. This announcement bode well for H-shares, which are generally trading at a substantial discount to its A-shares counterparts.

Limited A-shares exposure

Greater China and China equity funds primarily invest in H-shares and red chips listed in Hong Kong and other markets to gain exposure to the China equities. Some funds may also invest in selected B-shares, which are Chinese companies listed in domestic markets that foreign investors like mutual funds may invest in, which often times, is not as liquid as the H-shares markets. Although not all the funds disclose their breakdown of different shares, out of the Greater China and China equity funds that we have on our platform we see that these funds either have none or only very little exposure to domestic A-shares. Thus, the direct exposure to the volatility of the A-shares would be minimal. Let's take a look at the exposure that our FSM recommended China/Greater China funds has to A-shares.

HSBC Chinese Growth, one of our recommended funds for Greater China, invests primarily through Hong Kong listed Chinese companies through H-shares (65.1% of its holdings), red chips (28.4%) and Hong Kong China plays (3.4%), as of end March 2007. It also has a very small exposure in B-shares, at 1.1% and 0.5% respectively in Shanghai and Shenzhen listed shares. There is no report of any exposure in A-shares.

First State Regional China Fund is another one of our recommended funds for the Greater China region that invests across the straits, taking exposure in companies in mainland China, Taiwan and Hong Kong. It invests in H-shares (16% of its holdings), red chips (19%), Hong Kong (29.6%), China B-shares (7%), A-shares (1.7%) as well as Taiwan shares (24.9%), as of end March 2007.

Conclusion

Valuations for China markets as represented by HSMLCI are still moderate, compared with historical levels as well as the domestic A-share markets. As of end March 07, earnings growth in 2007 is estimated at 28.2% for 2007 and 17.7% for 2008, which are still supportive for moderate valuations. Nevertheless, investors should take note that even though the A-shares and the H-shares markets are not directly exchangeable, some of the underlying companies are the same. In the event there is a drastic correction in the A-share markets, the H-shares would also be affected from a spill-over effect, indicating higher risk associated in investing in the China market.

Investors who hold China equity funds which benefited from the bull-run beginning last year are advised to rebalance their portfolios. For instance, if an investor had held 20% of his portfolio in a China equity fund, and seen its value shoot up by 50%, this would mean that China equities take up a whopping 30% of his overall portfolio. That may mean that if China A-shares are hit, and ripple effects hit the H-shares (which is a more heavily weighted holding by China equity funds), this particular investor will suffer from rather strong volatility. Thus, we suggest that investors facing a similar situation should switch out some portion of his China equity fund into other funds to maintain a smaller exposure. In this case, for this particular investor, we would advise him to at least pare down his total holdings in China equities as a proportion of total equities, to 20% of his portfolio.

The rebalancing act allows investors to maintain a diversified portfolio to avoid taking on excessive focused risk. We maintain positive on the China market under a 3-year time horizon, and we retain the 3.5 stars or 'Attractive' rating on the market. For investors who have not invested into China or Greater China Equity funds, they may consider such funds as part of their supplementary portfolios.

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