Tuesday, May 5, 2015

Monetizing Chinese A-Shares

 I wasn't expecting to write another commentary so soon, but my favorite investment has performed so well that it was required.  China is the top performing major stock index of the last year; the Shanghai Composite is up a whopping 120% since last June.  I remain long-term bullish on China but it's no longer an obvious relative value play.  Also, the A-shares of duel-listed Chinese companies are trading 32% over identical shares listed in Hong Kong.  I sold all of my A-shares.   I've re-invested 1/3 of the capital in Chinese H-shares, 1/3 into a diversified emerging market ETF, and the last 1/3 I'm putting into precious metals as I continue to anticipate continued currency depreciation globally.  
 A-shares are Chinese equities that are listed on exchanges in mainland China and denominated in Renminbi.  Many companies also issue H-shares (listed in Hong Kong), and B-shares (a class that was created for foreigners before China allowed foreign investors to purchase A-shares)  Prices between exchanges can diverge greatly because of regulatory challenges to arbitrage and tremendous buying pressure from Chinese locals.  A-shares are predominantly owned by Chinese locals, while B and H-shares are predominantly owned by foreigners.   If you're looking at broad indices of these share types though, there are other differences; many companies only list a single share class, and the A-shares tend to be smaller and less internationally focused companies.  The surge in A-shares relative to H-shares suggests that most of the buying pressure was from Chinese locals; I've seen many other statistics to back this up.  Most of the westerners I talk to have been continuously pessimistic on Chinese equities and remain so.   


 Are Chinese equities overvalued now?  Is it a bubble?  I don't think so.  First, the simple valuation metrics suggest fair value, although it depends heavily on the specific index you're looking at.  Chinese H-shares have a P/E ratio of about 18 (vs 18 for the S&P 500) and a P/B ratio of about 2.2 (vs 2.9 for the S&P 500), while A-shares are trading at about a 35% premium.  The Chinese economy is growing at around 7%, vs the US' anemic 0.2% in the latest report (or closer to 2% if we ignore the last quarter).  Now, no one knows just about how much fraud is in Chinese reported earnings.  Back in 2008 I sold all my Chinese equities when I started delving into their financial statements and spotted massive fraud in minutes in every statement I examined (even with my superficial accounting skills).  One fun example was a Chinese mining company that claimed to be selling raw minerals at 5x the going market rate.  In 2009, the narrative of "you can't trust Chinese accounting" took hold and western investors have eschewed Chinese equities ever since.  While there's still lots of fraud (and I can't even try to quantify how much) the Chinese regulatory infrastructure has improved and standards are higher now.    


 From a psychological perspective, I think things are balanced to bullish.  Local Chinese citizens are speculating on margin in ways that are being compared to daytraders in the US in 1999, but that may be just the start of a trend with a long way to run.  The real estate boom is over, and the rates offered by banks on savings accounts are artificially low, so equities look attractive to the average Chinese person.  China is generating tremendous wealth that has to go somewhere.  Also, western investors missed the boat completely and remain pessimistic.  This means that if sentiment turns, there could be a flood of western money pushing Chinese equities higher.    


 What about the Chinese economy?  China is facing some huge problems but has equally massive tools at their disposal to deal with them.  They have excessive debt at the state level, too much of their financial system is corrupt and un-regulated, capital markets are underdeveloped, and their environmental problems are growing worse.  To even superficially touch on each of these would require a full essay, but I'll point out some of the highlights that explain my optimism.  China has the policy tools to stimulate growth.  While the US was "pushing on a string" and had to invent new monetary tools to encourage lending despite 0% interest rates, China has tremendous room to ease, and they've been using those tools intelligently.  Bank reserve requirement rates in China are at 18.5%, up from 7% in 2005, for example.  Additionally, while state banks are over-levered, small businesses and households are under-levered.  The Chinese government has passed a number of laws recently to encourage the formation of more small banks, bring greater transparency to the shadow banking system, more accountability to state finances, increasing lending to small businesses and decreasing lending to the largest SOEs, and new laws to accelerate the resolution of non-performing loans.  A few specific examples all from the past 18 months:  the Chinese government injected 500 billion RMB into the biggest 5 commercial banks via the Standing Lending Facility, and then another 400 billion via the CDB.  They injected 1 trillion RMB into the China Development Bank.  They cut taxes on utility companies and for manufacturing investments.  The central government passed a series of laws requiring much greater transparency in the budgeting process of local governments and forbidding municipalities from raising debt through off-balance sheet vehicles.  They are gradually opening capital markets via reduced currency controls and a wider RMB trading band; mainland Chinese mutual funds can now invest in H-Shares, and there are reduced restrictions on foreign investment in private companies.  There are a growing number of free-trade zones including Shanghai, Guangdong, Tianjin, and Fujian.  Lastly, the Chinese government is seriously cracking down on corruption - hundreds of thousands of party officials have been investigated with many senior officials arrested, including at least five members of the powerful Central Committee, and 70 executives of State Owned Enterprises.  This is just a small sample of recent reforms initiated by the Chinese government to overcome their obstacles.



Big Picture:Most assets are overvalued.  US equities and real estate are moderately overpriced; venture capital, biotech, and bonds are in or near bubble territory.  European and emerging market equities look roughly fair.  The global money supply continues expanding.  My own portfolio consists of emerging market equity, a small amount of european equity,a little commodity related equity exposure, and a small short S&P 500 position that I just initiated as a partial hedge to my long equity exposure.  I am also long a growing amount of precious metals and bitcoin.  



Cheers,
Ari