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Why China's stock market surge is too powerful to ignore

April 13
10:13 2015

China’s stock market is up 20 per cent this month, 30 per cent for the year and almost 100 per cent over 12 months.

China’s stock market is on fire. The Shanghai Stock Market Index is up 20 per cent just this month, 30 per cent for the year and almost 100 per cent over 12 months. This week’s it’s been the turn of Hong Kong’s large cap index which surged 10 per cent. This is a bull market of such scale and veracity that is impossible to ignore given the sheer numbers involved.

On Friday, US$ 250 billion of Chinese stocks changed hands more than the combined volume in US equity markets. And as if to celebrate the giddy rise, a stockbroker, GF Securities, floated itself on the Hong Stock Exchange and duly surged 42 per cent. The fund managers who got allocations enjoyed a massive payday based entirely on Chinese share-market hubris.

But the frenzy that is the state of the Chinese stock market naturally has Western investors scoffing that the epic flow of ‘dumb’ money into Chinese stocks is at odds with fundamentals and is fuelling a speculative bubble.   

And they have a point. There’s real evidence to show that the new wave of investors in Chinese stocks, on paper, is not that smart. A well-circulated Bloomberg Briefs graphic breaking down the level of education attained shows that investors piling into the market today have on aggregate a lower level of education than the previous vintage of speculators. The number of punters with a high school degree or less now accounts for more than half of new investors, compared with 26 per cent of existing investors.  

One ‘tremendous put’

That may be the case but it would be a bad idea to go against what is a seemingly unstoppable tide of money flowing into Chinese stocks.

The bull case for Chinese stocks was put forward in September by James Aitken. In an interview with The Australian Financial Review,  he explained that a “put” had effectively been placed under the market by Chinese policymakers who were keen to inject liquidity into the system to help it transition through a weak patch.

“The Chinese authorities are all in and there is tremendous put [option] under Chinese assets,” he said.  

Since then there have been some key regulatory initiatives directly relating to the stock market, and its really taken to the sky. 

The big-bang moment has been the introduction of the Hong-Kong Shanghai Connect programme that has allowed investors in each market to buy securities in each market. Chinese onshore punters can now buy the big Hong Kong stocks while foreign investors have access to onshore stocks.

It now seems like that this has turned into the watershed event it was billed as in transforming China’s capital markets.  And if China is indeed adopting a more Western-style financial system where markets rather than policymakers paly the central role in allocating capital, there’s no better way to encourage more capital to flow into the markets than through a rampant bull market.

But after the stampede are Chinese stocks now excessively valued? Well they’ve certainly been more expensive. Even after a 27 per cent surge since the start of the year, the Hang Seng index is still 13 per cent off its peak reached in late 2007. Also relative to other global comparisons, their valuations aren’t out of control.  

Room to rally

The share price of Bank of China has increased 77 per cent since October yet its price to book of 1.14 times compares with about 1 times book for JP Morgan and 3 times for Commonwealth Bank. There are other stocks that look cheap to some. 

One of Australian global fund manager Platinum’s favourite stock picks is Kweichow Moutai – a Chinese alcoholic spirit brand that suffered because of the well-documented corruption crackdown. But its growing sales at rates of 20 to 40 per cent, and at a price-to-earnings valuation of 14 times, the fund manager believes it is cheap compared with the 17 times valuation of Nestle, which isn’t growing nearly as quickly.

Shanghai Automotive was another of its picks discussed in its most recent fund update, which at a price-to-earnings ratio of 8.5 times and a dividend yield of 5 per cent appeared attractive.  

Platinum is one of a few global stockpickers that regard Chinese stocks as cheap, which suggests there may still be room to rally on valuation grounds.

“There is no question that the Chinese economy has slowed significantly as the credit-fuelled investment boom has come to an end.  It is highly likely we will see a significant rise in bad debts for Chinese banks,” wrote Platinum’s Andrew Clifford. 

“Yet it is exactly this risk that global investors are trying to avoid that is giving us an opportunity to buy companies at very attractive valuations,”

For now it seems momentum, the weight of money, the will of policymakers is behind China’s sharemarket rally. And if it keeps going, it’s a matter of time that more international funds feel compelled to enter the hottest stock market around.

China hellbent on developing

The problem for many Western investors remains transparency. They’re still relying on Chinese disclosure and Chinese auditing firms to vet the accounts. They’ve had bad experiences in the past and are not yet willing to blindly venture into the unknown.

But that misses the broader trend that China is hellbent on developing its financial markets and that means the growth in share market activity is only just getting started.

With billions of dollars changing hands, a whole lot of inefficiencies and trading opportunities are opening up. The Chinese market is providing a haven for hedge funds that can identify mis-pricings and make markets.

That’s a good thing for the region.

You don’t have to go long Chinese stocks to appreciate the centre of financial market gravity is shifting in our direction. 

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