Why Investors Can Still Find Value in China’s Red Hot Stock Market

Investors remain wary about China’s economy, particularly as the country’s development model matures, resulting in a slower growth rate. No doubt, it is going to be a volatile stock market. But investors can still find value as Hong Kong-listed Chinese companies have been trading at an attractive discount to A shares. At this point in the cycle, a combination of monetary loosening and reform measures has drawn capital into the red-hot A-share stock market. The euphoric environment in the A-share market will likely continue to spill over to the Hong Kong market.

After gaining 55.8% in 2014, the Shanghai CSI 300 Index went up by a further 14.7% in the first quarter with much of the returns coming in March. The euphoria has undoubtedly been boosted by greater retail participation as new brokerage accounts were opened at a record rate of 1.67 million per week. It is unsurprising that regulators are worried that a potential bubble is forming and the government may seek to divert capital out of the A-share market.

A-Share Momentum Spilling Over to Hong Kong

One diversion for the strong capital flows in China’s A-share market is the Hong Kong stock market. The discount between A and H shares that are dually listed in the mainland and Hong Kong stock markets has hit a recent high of 35% at the end of March 2015, according to the Hang Seng China AH Premium Index. Coincidentally, at the end of March, the China Securities Regulatory Commission (CSRC) announced that domestic fund management companies can buy Hong Kong-listed shares via the Shanghai-Hong Kong Stock Connect program without a Qualified Domestic Institutional Investor (QDII) license requirement.

In China, the further opening up of the capital market via the proposed Shenzhen-Hong Kong Stock Connect, as well as the potential A-share inclusion in international indices, will act as a long-term catalyst. The current market environment should benefit value investing as investors are more focused on the merits of each company on a fundamental basis and less so on a few small, fast-growing sectors. Despite the strong rally recently, the long-overdue recovery in China-related stock markets has only just begun and you can still find value in the Chinese equity markets.

China’s Reforms Address Slowing Growth

The People's Bank of China, PBoC, decreased the reserve requirement ratio, or RRR, for all banks by 1 percentage point to 18.5%, effective from April 20, marking the second cut in two months. The RRR was cut an additional 1 percentage point for rural credit cooperatives and village banks and 2 percentage points for the China Agricultural Development Bank. The cut will make available 1.2 trillion yuan (US$ 194 billion) to support small and medium enterprises, agricultural and infrastructure projects.

On February 28, the PBoC announced a symmetric interest rate cut of 25 basis points to 5.35%, effective March 1, following a cut in November.

With the establishment of a deposit insurance scheme, interest rate deregulation will likely happen earlier and improve the efficiency of capital allocation. With lower lending rates, banks may consider lending more to the private sector to maintain margins. Investors are hopeful that some of the pilot programs announced in the third quarter of 2014, especially the reduction of capital expenditure that is driving state-owned enterprise (SOE) reform, will see some initial results in 2015.

In 2015, we believe the government’s performance will be judged more on reform execution, and less on growth. Reforms, driving governance and growth, will likely reverse the price-to-earnings de-rating trend of Chinese stocks and bring about significant multiple expansion in the coming years.