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Frothy Chinese A-Share Market Can Yield Winners

Despite the threat of a correction, investors who do their homework may find opportunities in mainland China stocks.

This month China passed another milestone on its long journey toward full-blown capitalism. Vanguard Group announced that it would include renminbi-denominated stocks from mainland China, known as A shares, in its $69 billion Vanguard Emerging Markets Stock Index Fund.

Vanguard’s move, combined with the likelihood of a similar action by index giant MSCI in the near future, stands to increase the flow of foreign money into the A-share market. Does the $3.3 trillion asset manager stand a good chance of delivering strong returns to investors, or is it walking into an enormous bubble?

Some parts of the A-share market look inflated following a rally that has seen most mainland stock indexes more than double over the past 12 months. Lately, this surge has shown signs of fatigue, though, with the Shanghai Composite and Shenzhen Composite indexes both losing some 20 percent in just two weeks.

“A-share market small caps are trading at outrageous valuations,” says Jian Shi Cortesi, a Zurich-based investment manager and China specialist at GAM, an arm of GAM Holding, a Sf123 billion ($134 billion) Swiss asset manager. ChiNext, a Nasdaq-style board for growth shares that is part of the Shenzhen Stock Exchange, closed at a trailing price-earnings ratio of 115.5 on June 18 after the index more than doubled in value since the start of the year. China’s retail investors, who account for the bulk of A-share trading volume, have figured heavily in this rise.

For large-cap stocks the picture is less extreme. The Shanghai Shenzhen CSI 300 index of large-cap A shares, which was up 125 percent in the 12 months to June 25, sported a trailing price-earnings ratio of 20 times. That is toward the lower end of its historical range between the low teens and about 50 but well above the current P/E of 12 for the MSCI China index, which is dominated by Hong Kong–listed Chinese stocks, known as H shares, and excludes A shares. Given this gap, the current ratio for A shares is “difficult to justify,” according to Shi Cortesi.

The Vanguard Emerging Markets Stock Index Fund, a passive investment vehicle, will introduce a 5.6 percent weighting based on 1,411 China A shares out of a total of roughly 2,200. “We expect the transition to begin late in 2015 and to take about a year,” a spokeswoman for the firm told Institutional Investor. Valley Forge, Pennsylvania–based Vanguard’s move followed the May decision by FTSE Russell, the index provider used by many of the firm’s funds, to launch versions of its FTSE Global Equity Index Series that will include A shares.

A few days after the Vanguard announcement, MSCI said it planned to include A shares in its global benchmarks once certain conditions were met. Among the investor concerns listed by MSCI: the desire for a more streamlined, transparent and predictable process for allocating A-share quotas to institutions, and for an easing of limits on capital repatriation. MSCI is working with the China Securities Regulatory Commission to address those issues and could include A shares in its MSCI Emerging Markets index within 12 months.

The consensus is that the A-share market is at risk of a correction, thanks to the inflated ratios for price-earnings, price-to-book-value and other measures. “It probably will deflate at some point, though we don’t think we’re at that point yet,” says Nicholas Beecroft, portfolio specialist in Asian equities with $773 billion T. Rowe Price in Hong Kong.

But this still leaves plenty of possibilities for fruitful stock selection by active investors who China-focused investment managers think will follow Vanguard in adopting the new FTSE Russell benchmarks.

“Although the A-share market as a whole has rallied significantly and valuations have inflated to worrying levels in parts of the market, there are pockets that look attractive,” says Jennifer Wu, London-based vice president and client portfolio manager with the $92 billion emerging-markets and Asia-Pacific equities team at $1.7 trillion J.P. Morgan Asset Management. JPMAM favors companies likely to gain from long-term structural growth in their sectors, including information technology, health care, tourism and other forms of discretionary consumption.

Some of these opportunities aren’t fully available among Hong Kong–listed companies, investors note. “For some areas of the consumer and industrial market, as well as health care, the A-share market provides broader, deeper exposure to opportunities in China than you can get through the H-share market,” says Beecroft of Baltimore-based T. Rowe Price.

Although his firm has only two A-share stocks in its Asia ex-Japan strategies — Kweichow Moutai Co., a producer of Chinese spirit baiju, and Weifu High-Technology Group Co., a maker of catalytic converters — Beecroft expects more A shares to be added over the next few months. Based in Renhuai and Wuxi, respectively, Kweichow and Weifu are both trading at a modest multiple of about 15 times expected 2016 earnings.

Beecroft thinks the most extreme hysteria among investors has been limited to small caps and so-called concept stocks, those centered on some new idea that can be easily grasped, even if it’s untested. Beijing Baofeng Technology Co., a Beijing-based online video company bid up 43 times since its March initial public offering, was trading at a trailing P/E of 654 and price-to-sales of 74 on June 22.

“Things that may be viewed by retail investors as a little more boring haven’t caught their imagination,” Beecroft says, giving the example of catalytic converters.

Still, he and others say that as international investors keep entering the A-share market to play an active role, change will follow. A love of boring but profitable things, and a wariness about untested ideas that have not yet generated much profit, will inject more rationality into the mainland China stock market.

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