Promise and peril in Chinese equities
No. 1 market rockets ahead, but how much upside is left?
By Bill Clifford, CBS.MarketWatch.com
Last Update: 7:52 PM ET July 6, 2001
marketwatch.com
SHANGHAI, China (CBS.MW) -- This dragon baby is growing up fast. A little too fast, some
might say.
Riding a fiery economy poised to rip
down ancient walls impeding global
trade and investment, mainland China's
home-grown stock market has left rival
exchanges in Hong Kong, Asia and the
rest of the world behind in the New
Economy dust.
Talk about all-stars -- try these for
slugger stats year to date. Shanghai
shares: Up 133 percent. Stocks on
China's Shenzen market: Up 142
percent. Not counting Japan, these are
the equities that have built Asia's
biggest market in terms of combined
stock market value.
'Scope for setback'
Of course, numbers like that don't last
forever. Says Edmund Harriss, a bullish
manager of the Investec China & Hong
Kong Fund: "China is an emerging
market, and there's always a scope for a
setback." Paste those words
somewhere near your portfolio tracker.
Analysts say the peak may be near -- if
not already passed -- for the boom-time
market's forces like 8 percent annual
economic growth and the countdown to
joining the World Trade Organization,
the global club of free-trade nations.
Yet even if Chinese shares do nothing
but tread water in the next six months, the country's 10-year-old stock market is well on its way to
finish 2001 as Asia's top performer -- and one of the world's best -- for the second year in a row.
Even another sharp correction like last month's setback would leave the Shanghai and Shenzhen
exchanges comfortably above Asia's next-best performer. At the moment, runner-up honors belong to
tiny Thailand's benchmark SET, up 21 percent through Friday.
And bully for the China bulls if the alphabet soup of Chinese equity categories keeps bubbling higher.
With that possibility still alive, so are the prospects for domestic and non-Chinese investors alike.
But further rallies in the mainland's "A shares" and "B shares" aren't likely to find support from faster
economic growth and broadly improving corporate earnings for much longer. Class A shares are the
equities reserved for domestic-based investors, and Class B shares, until a few months ago, were
legally open only to overseas players.
Also ebbing and flowing with the mainland tide are "H shares" (for mainland companies that list on
the Hong Kong Stock Exchange) and red chips (Hong Kong companies with significant mainland
ownership and operations), but these tend to trade with less volatility. Many of them can be seen as
"N shares," if they're also listed in New York.
Besides China-oriented mutual funds, individual U.S.-based investors who want to play such stocks
directly can tap into the American depositary receipts of China Mobile (CHL: news, msgs, alerts) ,
Brilliance China Automotive (CBA: news, msgs, alerts) , PetroChina (PTR: news, msgs, alerts) and
other darlings that have journeyed to Wall Street.
Tougher listing standards mean the finances of such companies are more transparent to investors.
Even so, the overlapping exposure these companies have to Chinese and global business conditions
often makes them nearly as tough to analyze as the opaque mainland pure-plays.
Dragon's tale
What began as The Great China Growth Story has unfolded in recent years as an
earnings-momentum phenomenon. And yet, to hear some market professionals now tell it, China's
economy is probably on the verge of slowing and equities have gotten pricey -- the average
price-to-earnings multiple stands near 70 for A shares and hovers around 40 for B shares.
"China is the only market in Asia outside Japan to be overvalued," says Anthony Muh, regional head
of investments for Citigroup Asset Management.
The world's most populous country, he adds, is also one of the few in Asia that is still "showing good
earnings growth momentum. As long as the earnings growth profile remains there, the markets can
trade overvalued for a period of time."
It's hard to say how long that'll be, partly because the latest twist in this tale -- a great wall of liquidity
-- has intoxicated many while pushing valuations ever higher.
In mid-February, securities regulators eased restrictions on the 60 million individual Chinese investors
who had A-share accounts and other locals whose savings were parked in low-interest bank
accounts. Suddenly, the doors were thrown wide open for them to buy foreign-currency denominated
B shares, which had been reserved for but largely shunned by foreign investors.
And buy they did, often on little more than rumors. Then came a rather big rumor: Mainland investors
would also be given the green light for trading in Hong Kong-listed H shares. Chinese authorities are
not about to make the local currency, the yuan, convertible anytime soon for fear of triggering an
exodus of capital. But local investors acting on the rumor wasted no time stuffing hard currency into
suitcases that found their way across the border. In early June, Beijing began cracking down on
brokerages that used other channels to give clients access to Hong Kong share trading.
That took some air out of what struck many as an H-share bubble. H shares, tracked by the Hang
Seng Chinese Enterprises Index, trade at a significant discount to A and B shares, with an average
P/E multiple in the low double digits.
Tempting themes
Liquidity in China's casino culture isn't the whole story, of course. Also fueling bullish sentiment: the
Chinese economy officially grew a faster-than-expected 8.1 percent in the first quarter; China looks
set to get final approval in November for its 15-year struggle to join the World Trade Organization; and
Beijing is regarded as a front-runner to be selected July 13 to host the 2008 Summer Olympics.
But buyer, beware. Sentiment along these lines could turn fickle.
As sensational as the latest GDP figures appear -- particularly since growth is unusual just about
everywhere else in the world -- it often pays to treat Chinese data as you would one of Oliver Stone's
cinematic historiographies.
There's a credibility issue, and it won't go away as long as state-owned enterprises remain under
pressure to produce goods for production's sake while much of their unsold inventories elude
bean-counters.
And then there's the overstated idea that China has escaped the global slowdown. "China is less
exposed," says Marcel Souza, regional economist at Invesco Asset Management Asia. "But it is not
immune altogether. Exports are slowing."
Electronics such as radios, cameras, CD drives and low-end semiconductors, make up about a fifth
of China's shipments abroad. For now at least the overseas appetite for these goods is shrinking.
That puts more pressure on Chinese consumers to pick up the slack, and U.S. fund managers are
taking note.
"We are now overweight in consumer stocks because we like the prospects for that group," says
Richard Gao, co-manager of the $23.7 million Matthews International China Fund (MCHFX: news,
msgs, alerts) . Consumer durables and non-durables account for more than 10 percent of the fund,
which leads the China category with a 39.2 percent return year to date.
Legend Holdings, the mainland's largest maker of personal
computers (LGHLY: news, msgs, alerts) , claims 5.2
percent of the Matthews fund's total net assets. Other large
holdings include leading cellular operator China Mobile, a
Hang Seng Index heavyweight, and Zhejiang Expressway.
"We also like the auto companies," says Gao.
Even if such domestic demand-oriented enterprises drive
the economy temporarily, Invesco's Souza says that "China
remains on a slowing track."
Compared to 8 percent GDP growth in 2000, "growth even on official numbers could drop to 7 percent
for this year," Souza says, "and lower in 2002 if the authorities don't resolve problems in banking
system and create the right regulatory structure to keep demand strong."
Will membership in the WTO help? A more open Chinese market that attracts greater flows of foreign
capital "doesn't mean trade volume will pick up all of a sudden," says Queenie Cheung, an analyst at
Dresdner Kleinwort Wasserstein.
"But some foreign companies waiting for the agreement will set up offices and employ more people,
and that will feed through to consumption," she says.
Trading places
If WTO entry eventually leads to the creation of millions of jobs linked to the export sector, as
supporters expect, many millions of jobs will also be eliminated as state-run outfits continue to fold
and imports turn up the competitive heat.
"We can think of more losers than winners," says Citigroup's Muh. While textile and transportation
companies should do well, he says, "the banking, telecommunications and automotive sectors will
open up to fiercer foreign competition."
The aviation sector, which faces a future of mergers and
restructuring, will have its winners and losers. Several fund
managers prefer China Southern Airlines (ZNH: news,
msgs, alerts) to China Eastern Airlines (CEA: news, msgs,
alerts) . China Southern, they say, is well positioned to
make acquisitions to enhance its domestic routes, which
are more profitable and better shielded from competition
than the international routes that are key to China Eastern's
business.
Irene Chow, Citigroup portfolio manager for North Asia, says
she likes China's independent power producers. While there's consistent demand, the capacity
cutbacks, power shortages and other occasional constraints on the supply side have favored
operators such as Huaneng Power (HNP: news, msgs, alerts) , Shandong International Power
(SDGIF: news, msgs, alerts) and Beijing Datang (BJDHF: news, msgs, alerts) .
"Huaneng can invest in greenfield projects and buy assets from its parent company," Chow says.
"We're currently holding Huaneng because of its strong growth potential, and we don't think the
valuation is stretched."
Those are the very same arguments that analysts and
professional investors make in favor of China's oil giants
PetroChina (PTR: news, msgs, alerts) , Sinopec (SNP:
news, msgs, alerts) and CNOOC (CEO: news, msgs,
alerts) . What's more, Sinopec and PetroChina -- both of
which are listed in Hong Kong and New York -- are planning
massive A-share issues on mainland exchanges. See full
story.
Typically, huge placements of additional shares would be a
negative, but there's an enormous demand among
mainlanders for better-quality stock. Many expect the local market to absorb the issues easily and
give a kick to the overseas share prices.
Beijing aims to privatize and list hundreds of enterprises so that proceeds can be used to fund new
public investment and to pay burgeoning, unfunded pension commitments. There are numerous risks
and obstacles to developing a sophisticated securities market in China over the coming years.
Foreign investors also need to bear in mind the influence the Communist party has in corporate
governance, through seats on listed companies' boards, may or may not coincide with minority
shareholder interests.
Bargains scarce
After such a strong rally in Chinese equities, value investors will find bargains are scarce even among
Old Economy plays in the railways, oils, utilities, distribution and basic manufacturing sectors --
industries that will mold China into the world's No. 2 economy after the U.S. in the first half of this
century.
And it may be too much to hope for that mainland retail punters will absorb soon the disciplined
investing methods of somebody like Thomas Tuttle, who manages the $55 million Liberty Newport
Greater China Fund (NGCAX: news, msgs, alerts) . "Newport has always taken a conservative
approach in Asia," says Tuttle. "Our whole approach is to find companies that have large, predictable
growth."
Mutual funds that invest in Greater China, reflecting the dour results of Hong Kong's market, on
average have gained only 0.7 percent through the end of June, according to fund-tracker Lipper Inc.
However, that compares with losses of nearly 11 percent for the average international stock fund and
a drop of 5.8 percent for the average U.S. stock fund.
Many of the China country- and regional-focused mutual funds tracked by Lipper have holdings in
companies in Old Economy sectors as well as in finance, real estate and high-growth sectors like
cellular phone companies.
China Mobile and rival China Unicom (CHU: news, msgs, alerts) are key holdings for the $9 million
Investec Mainland China Fund (ICHNX: news, msgs, alerts) , which is up 8.4 percent year to date.
The $100 million Investec China & Hong Kong Fund (ICHKX: news, msgs, alerts) also holds both, and
fund manager Edmund Harriss says he's more partial these days to Unicom because of its valuation
and subscriber growth rate.
Harriss, whose fund is down more than 11 percent this year, devotes about 75 percent to 80 percent
of the portfolio to Hong Kong stocks, mainly banks and property groups. Because the Hang Seng
Index is Asia's worst performing benchmark this year excluding India's stock benchmark, China funds
with large stakes in Hong Kong have been held back.
Bill Clifford is Asia bureau chief of CBS.MarketWatch.com. Staff reporter Justin Wiser in Washington
contributed to this report. |
