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The Rise of China’s Nasdaq

The launch of the Shenzhen-Hong Kong Stock Connect program will allow foreigners to invest in China, but some investors are skeptical.

  • Allen T. Cheng

Hong Kong– and Singapore-based Mark Mobius, the executive chairman of Franklin Templeton’s Emerging Markets Group, has long seen things before others do.

Famously prescient on emerging-markets equities in the 1980s, Mobius, 80, has lately been preparing for another opportunity that he believes is also too good to miss: the launch of a Shenzhen-Hong Kong Stock Connect program that allows him to invest in high-growth Chinese stocks — especially those in the technology sector — while bypassing China’s quotas and other restrictions on foreign investors.

“With the launch of the Shenzhen-Hong Kong Stock Connect program, many foreign investors can invest in China, where there are tremendous opportunities in every area of the country,” Mobius tells Institutional Investor of the soon-to-be-launched program that connects the Hong Kong exchange with the Shenzhen Stock Exchange, which offers a pool of 1,400-plus private enterprises and is known as the Nasdaq of China. “We think this could be a very exciting opportunity to invest in Shenzhen technology stocks, where there are many undiscovered and smaller Chinese technology enterprises.”

The connect allows investors in both Hong Kong and mainland China to trade equities listed on the Hong Kong and Shenzhen exchanges, bypassing many cross-border investing restrictions the government imposes on foreign and Chinese investors. The trading program, expected to kick off by Christmas, follows the launch of the Hong Kong-Shanghai Stock Connect in November 2014. The tie-up between the Hong Kong and Shenzhen exchanges is Beijing’s latest financial reform initiative, which analysts believe — if successful — will encourage more global asset managers to make mainland China-listed equities a significant part of their international portfolio allocations. (Many managers currently invest in China primarily through Hong Kong–listed Chinese companies and have limited exposure to mainland equities through special quotas and Qualified Foreign Institutional Investor licenses that allow them to buy via a domestic Chinese fund manager or broker.)

The Shenzhen-Hong Kong Stock Connect will still have a 13 billion yuan ($1.94 billion) daily quota, but regulators have decided to lift all aggregate quotas, which previously saw a 300 billion yuan limit for northbound investors and a 250 billion yuan limit for southbound investors. With the launch of the second connect program at the end of this year, investing in Chinese equities becomes a lot easier as all investors — big and small, domestic and foreign — will be able to invest in a significant number of the nearly 3,000 companies listed on mainland exchanges, as long as they have trading accounts with brokers in Hong Kong, Shanghai or Shenzhen.

“The recent approval of the Shenzhen-Hong Kong Stock Connect program facilitates foreign and domestic trading between China’s local market and Hong Kong — and to global investors like Franklin Templeton, this means China’s A-share market is further opened up,” says Mobius, who manages $22 billion at the Emerging Market Group. Mobius also says Shenzhen offers more private companies than Shanghai, which is dominated by state-owned firms. Mobius further notes that he believes China’s stock markets, commonly referred to as the domestic A-share market, will benefit from higher participation from foreign investors, especially institutional investors. “It is a positive development as global investors may potentially provide greater breadth in the near term and, longer term, can help drive the push for better corporate governance, a better regulatory framework and stricter enforcement.”

Not all global investors are as sanguine as Mobius, however.

Wayne Bowers of Chicago-based Northern Trust Asset Management takes a more cautious view. The London-based chief investment officer for Europe, Middle East, Africa, Asia Pacific says he will look at how the program operates before he commits to expanding beyond his current allocation to Chinese companies listed in Hong Kong and the U.S. “Although we do not make specific comments on future investment allocations, we generally expect that the new channel will open up additional opportunities for future allocations,” Bowers says. “While access is a key component of a decision to invest in a new market, investors may also look for the market to function efficiently and transparently before having the confidence to make a meaningful allocation to mainland equities.”

One of the challenges for investors buying into the Shenzhen market is finding gems in an already expensive market dominated by technology companies with high valuations. Equities in Shenzhen are trading at an average price-to-earnings ratio of around 40 per share, substantially more expensive than the average PE ratio of 20 in Shanghai, where many of the 1,090 companies are state-owned enterprises, and the average PE ratio of 16 in Hong Kong, where more than 60 percent of the 1,800 listed companies are from China, both state-owned and private.

“The growth opportunity — private enterprises and new economy — in Shenzhen is four times larger than Shanghai,” says Erwin Sanft, the Hong Kong–based head of research at Sydney-based Macquarie Securities. “Yet valuations are higher and the market is more volatile.” Still, Sanft says, there are dozens of equities worth investing in, among them the shares of GoerTek Inc., one of China’s leading acoustic components companies that has been expanding into virtual reality software development, and Shenzhen Rapoo Technology Co., a wireless electronics component manufacturer that has been expanding into industrial drones and robotics.

Besides giving global investors more options, the new connect is a technological innovation that unifies China’s three equity exchanges, says Francis Cheung, the head of strategy for Hong Kong and China at CLSA, a Hong Kong–based securities firm that is a subsidiary of Beijing-based CITIC Securities. “It is seamless to investors no matter which exchange the stock is listed in,” says Cheung. The three exchanges have a combined market cap of more than $10 trillion, making China the second-largest equity market in the world, behind only the U.S.

The new connect also strengthens China’s chances of winning inclusion in MSCI’s emerging-markets indexes, says Patrick Ho, the Hong Kong–based head of Asian equities at Sydney-based asset manager AMP Capital. “MSCI inclusion for China is expected to be six months after Shenzhen Connect implementation,” Ho predicts, adding that demand will rise for Chinese A-shares among global investors in Chinese equities once MSCI decides to include A-shares in its index allocations.

That will certainly be good news, says Mobius, adding that he remains optimistic about China’s economy — particularly its Internet and technology sectors, despite rising global concern about the sustainability of the nation’s economic growth.

“In our view, the fundamentals in China still look very good,” says Mobius. “The country remains one of the fastest-growing economies in the world despite a decelerated growth rate from decades past, and we remain confident in the government’s efforts to effect a broad economic rebalancing away from an export-driven model and toward one that is more domestic-oriented.”