If you had invested in Chinese stocks listed in Hong Kong (‘H’ Shares) at the start of April three Friday’s ago (27th March 2015) you’d have been 23% richer eight trading days later.
What’s going on? Great profits news? Positive economic data?
None of these. In fact, data has been poor. Figures released on Monday showed that Chinese exports, rather than rising 8-10% over the last twelve months as analysts had forecasted, actually fell by 15%. However, the H Shares market duly responded with a 4.3% gain.
So what has happened? Explanations for the recent moves are actually more unusual and centre on a scheme for financial liberalisation which has allowed domestic Chinese investors to buy shares listed in Hong Kong, and in turn opened up the onshore Chinese market (‘A’ shares) to foreign investors.
What has happened
This ‘Stock Connect’ scheme to open up markets was announced in November 2014. Until then market access had been restricted, meaning that Chinese investors could only hold shares listed on the Chinese market (and foreign investing in China was restricted). As a result, companies which listed in both China and in Hong Kong could have the same shares priced very differently.
But the Stock Connect scheme was initially lop-sided; while any foreign investor could now invest into the onshore Chinese market (subject to quotas), only very rich Chinese individuals could invest in Hong Kong. Since that point, the onshore Shanghai Composite Index significantly outperformed the H Share market (see figure 2).
Figure 3 shows more clearly how the move has impact the prices of the same share in different markets. The chart is a measure of how much higher onshore Chinese prices are than their Hong Kong-listed equivalents (a figure over 100 means that the Chinese share is a higher price).
On 27th March, the scheme was expanded to allow Chinese mutual funds (and not just individuals) to invest in Hong Kong. From that point we see H Shares appreciate rapidly and as a result, the premium for Chinese listed A Shares decline.
Why hasn’t the onshore depreciated as well?
The ultimate outcome of liberalisation should be for the two markets to gravitate to the ‘correct’ market price. This could happen through A Shares falling, H Shares rising, or a combination of the two. What we have seen is both markets rise, but the H Share rise more (see figure 4).
This seems counterintuitive if you were to believe in much market commentary. After all, the offshore market is open to the collective wisdom of all global institutions outside of China. The Chinese market on the other hand is often portrayed in the Western media as dominated by housewives and security guards, many of whom are more prone to gambling and are even illiterate (I leave it to the reader to make their own judgement on how this differs from any other market).
Surely the H Share is the more ‘efficient’ market? Why would global investors not sell the A Shares and buy the Hong Kong version?
So what now? Should we chase the closing of the premium?
The Episode team are sceptical of most flows-of-funds arguments as a framework for investing. It easily sends one down the route of Keynes’s beauty contest; second guessing the motivations of others and ignoring fundamentals. If you can do this well there is scope to make a lot of money. However, we think it is extremely difficult at best and prefer to look at fundamentals.
In the case of the H Share, while earnings yields (our preferred measure) have fallen from very high levels seen in 2013-14 amidst the height of shadow banking, property bubble, and Chinese slowdown fears, they still remain elevated relative to the last ten years or so, and certainly relative to a number of other global equity markets (see figure 5).
The Shanghai composite on the other hand arguably looks far less compelling in an absolute sense and the relative gap between the same shares listed on the different markets still looks elevated (figure 6).
Rather than trying to second-guess if, when, and how this gap will close, however we believe that the investment decision should ultimately come down to consideration of the merits of the individual position.
The threats that investors were worried about a year ago still exist (as do a whole number of risks which we aren’t conscious of at the moment). The question we must ask is whether the compensation on offer for taking these risks is attractive. If you didn’t think that was the case in 2014, then you certainly shouldn’t now.