There are many confronting issues when it comes to investing in the hottest market of the moment, China, but one of the first is getting on top of all of the different classes and their names. For foreign investors the best known are the so-called H shares, which are shares in Chinese companies listed in Hong Kong. A long time ago the government controlled companies were call red chips, and the private ones H shares, but now they are all H shares! By contrast A shares are shares in Chinese companies listed in Shanghai or Shenzhen. The confusion comes in because most of the large companies are listed in both Shanghai and Hong Kong.
Historically they have traded at quite different prices as global investors had limited capacity to invest in A shares and Chinese investors had limited capacity to invest in H shares. In the last year large cap A shares have gone up almost 90% and are about 20% above their previous peak about four years ago. By contrast H shares, which represent substantially the same universe of companies have only gone up about 40%, and have only just got back to where they were four years ago.
Chart 1: Ftse A Shares Index (white line) versus Hang Seng China Enterprises Index “H Shares” (orange)
It would be fair to say that some members of the Morphic team (and one in particular) have often joked that they have made a career by avoiding investment in China, due to distrust of the regulators; corporate governance and the integrity of financial reporting. This probably means a few missed opportunities, but he contends he also probably have more hair, with less of it in the grey category as a result, and was able to divert his energies to looking in more rewarding markets with less multi-faceted risks.
But things morph as we say at Morphic! and what has morphed in China is that over the last year or so we have seen:
- Some serious long term reforms in both the real economy and the finance sector, such as continuing slow loosening of the laws allowing people to settle in cities, and also gradual liberalisation of interest rates.
- Lower interest rates in China have resulted in more investors flooding into the share market, which has seen a succession of record turnover days
- Most recently we have a substantial loosening in the rules allowing foreign investors to invest in A shares, which helped drive those up further, in what is known as the “North bound through Train”
- Then in the last month we have seen the take-off of the South Bound through train, which has allowed Chinese mainland insurance companies and mutual funds to buy Hong Kong listed H shares. Since these investors already own more highly priced A shares in the same companies as are listed in Hong Kong they have snapped up the opportunity to buy these at an average discount of over 20% and in some cases discounts of over 60%.
The other thing that has changed is that for the first time we are starting to find some genuinely interesting well run companies with great long term growth stories, such as Ping An, the largest Chinese non-government financial firm which is the second largest life insurer in China and also the second largest general insurer. Ping An, on our estimates is trading about a 30% discount to what a similar high growth business would be priced at anywhere else in the world. About six months ago we decided we liked several of the toll road companies, which have done very well for us ever since, and still look reasonably priced. The opportunity there came because most investors who look at toll roads thought the regulatory environment was too scary in China, and most investors who look at China thought toll roads were too boring. We don’t mind boring, and we think Chinese national and provincial government requirements for these toll road companies to keep building their networks means they will do nothing to damage their financial strength for many years to come.
We believe the arbitrage between H and A shares has now closed by about 10 percentage points, but could easily close by another 20 percentage points (see chart 2 below that tracks the relative spread – this can return to 100 to be at par). That is exciting global equity managers like us who can go long H shares and short the A share index. But this is small beer compared to what is happening on the mainland. Promotors in China are rushing out new mutual funds to do the trade. The first one out to the printers, managed by Invesco has already raised RMB11 billion, or more than A$2 billion. The increasingly porous foreign exchange controls are also seeing private investors chase this arbitrage, which gives them the additional benefit of having gotten their money of China (and arguable some of this is just parked before making its way into the Sydney property market, but that is a blog for another day)
Chart 2: Hang Seng China AH Premium Index
Does all this mean that we are less cautious about the long term prospects for the Chinese economy, and by extension demand for Australian raw materials? Not at all. Our expectation is that growth will continue to slow towards 5% per year or even lower as the rate of fixed asset investment as a share of GDP comes down faster than domestic consumption picks up. But in the meantime the animal spirits in the Chinese stock markets (including Hong Kong and its H shares) will be driven higher by the same factors that have driven western markets to record post GFC levels over the last 12 months: the desperate efforts of central banks to keep the growth engine going through ever looser monetary policy, through what we term the “Bad news (for the economy) is good news (for the markets)” factor. In China’s case the pressure to keep cutting interest rates and removing other regulatory shackles from lending is made more relentless by the strong asset deflationary trends we are seeing.