Asia

Bull in a China shop

“Bull in a China shop”: someone who is careless in the way that they move or behave, a person that is clumsily destructive.

What goes up 150%? Mainland Chinese stocks in the year to early June. What goes down 43%? Mainland Chinese stocks since then. The net result is still a gain of 42% in little over a year. But more falls seem likely, despite the meddling and finger pointing of the Chinese authorities. If you look in the right places there are already bargains to be had. But best to wait for the dust to settle.

It’s not the first time China’s had a stock market bubble in its A-share market. A-shares are stocks priced in renminbi yuan and traded on the stock exchanges in Shanghai and Shenzhen. These are different from H-shares, which are stocks of mainland Chinese companies that are priced in Hong Kong dollars and trade on the Hong Kong Stock Exchange. (There are other lesser types of Chinese shares, but these are the main ones.)

And it won’t be the last bubble either. In most developed stock markets around the world the ownership of stocks and the volumes of trades are dominated by professional investors and speculators. That’s because those places have big fund management and insurance industries, with huge pots of money to invest.

In many emerging markets, such as Russia or India, markets are heavily influenced by inflows and outflows of international money. This is because their own investment industries are still immature and small. This leaves them prey to the vagaries of international fashion (but also opens up spectacular investment opportunities after everyone has run for the exits).

But the Chinese A-share market is different. It’s still mostly closed to foreign money, despite steps taken late last year to open the door a further crack (see here for more).

And activity is still dominated by “retail investors”, which in this case really means millions and millions of small time gamblers. These are people that trade on gut instinct and whim. They may have their own “systems”, but those have little or nothing to do with financial logic.

Also the market’s only been going since 1990. It was closed in 1949 due to the communist revolution, and was tentatively re-started just 25 years ago. But really it’s just a teenager (see here for more on the Chinese market and speculative bubbles in general).

Here’s a chart of the Shanghai Composite index since 1990. You can clearly see a massive bubble that peaked in 2007 and the latest one too.

Shangai Composite Index

And here’s a chart that gives a closer look at A-share price moves over the past year. It’s a classic boom and bust.

Screen Shot 2015-08-27 at 3.23.09 PM

And if you think your stockbroker is a chiseller and a charlatan, he’s most likely a positive paragon of virtue compared with mainland Chinese brokers. How do I know this? Because I’ve met a lot of them.

In fact, in the search for a Chinese joint venture partner for the international investment bank where I worked, I met and negotiated with a lot of Chinese brokerage firms.

Okay, that was a decade ago. And I’m sure that their standards of behaviour and the regulatory environment in China have both improved since then. But there’s still likely to be a lot left to be desired.

There were about 120 licensed Chinese brokerage firms back then. It was a highly fragmented market. To put that into perspective – around the world as a whole – there were just eight or nine huge investment banks that processed well over 90% of stock trades by value. (It’s much the same today – possibly even more concentrated.)

Stockbroking is an oligopoly is most countries, certainly in developed markets. In China it’s run by a school of sharks, and one that occasionally teaches the little fish some tough lessons.

At the time, the street level branches of these brokerages looked more like places to bet on the horses than investment venues. Ranks of the hopeful lined up in fixed plastic seats, watching prices tick up and down on huge screens, pencils poised to scrawl down buy or sell orders on tickets. Fundamental research into financial condition of companies or their prospects for profit was practically unheard of.

There are still over 100 active brokerages spread across China today. Most of them are small time outfits run for small time punters. Malpractice is bound to happen, just as it does everywhere in the world. Just more so in China.

This is the perfect environment for periodic bubbles and busts. Credulous hordes of the unsophisticated occasionally get swept up by collective mania. Unscrupulous insiders stand ready to profit when it happens.

Why is this important? Because it makes the stock market highly political. China may not have a democracy in the sense that most people understand the concept. But China’s ruling party still needs broad support for it to retain legitimacy. After all, it was born out of revolution against the last monolithic system of government that operated under dynasties of emperors. Modern day leaders know too well the perils of losing touch with the masses.

So, now that the latest bubble has popped, the government intervention and finger pointing begins. Just like everywhere in the world, but with a higher pitch and potentially far larger consequences for the scapegoats.

Hardly any of the big crooks at the centre of the US debacle between 2007 to 2009 ended up in jail. In fact many of them kept their jobs. The luckiest of all – who were often the most unscrupulous or incompetent – walked away with huge severance packages, in some cases running into hundreds of millions of dollars. But in China it’s different. I’d expect heads to roll, even if not literally.

Many people in China will have lost their shirts. If the market keeps falling they may lose the rest of their clothing too. It’s natural in a country where the government is at the centre of so much to point accusing fingers at the authorities.

Anyone except for themselves can be blamed, except for the ignorant and gullible small fry that set up the bubble in the first place.

So the politicians duck for cover. And once crouched down take aim at someone else. Brokers…illegal short sellers…foreigners…political enemies…regulators. Anyone except for themselves can be blamed, except for the ignorant and gullible small fry that set up the bubble in the first place.

And steps have been taken to try to stem the falls. Government controlled pension funds and the like have been ordered to buy stocks in an attempt to prop up crashing prices. For a while hundreds of stocks were just frozen. If they can’t trade then the price can’t fall (or rise), which is supposed to make people feel better. But it rarely works.

Much more likely, as also discovered in Greece recently, is that if you close all or part of the market it just delays the reckoning day. As soon as the market reopens it starts to plunge again. Take a look at the second chart above and you can see how Chinese government efforts stalled the plunge during July, only for it to resume during August.

And now it’s mea culpa time. On the first of April I wrote about how to make safe profits from the Chinese stock bubble. And just in case you are wondering…no, that wasn’t an April fool. Although I feel a bit like one.

The idea was to avoid the hugely expensive mainland Chinese A-shares and buy the much cheaper H-shares of Chinese companies, which are listed in Hong Kong. By the way, the Hong Kong Stock Exchange has been going since 1891. It’s much more developed than the A-share market.

The way to do this was via an H-share ETF called the First Trust China AlphaDEX Fund (NYSE:FCA). It looked like reasonable value, and perhaps even cheap at the time. So I believed that it would make a good long term investment for those looking for exposure to mainland China. I still believe that.

But in the short term things haven’t turned out so well. FCA followed the mainland bubble higher for about a month, but then turned and started falling in early May, while A-shares kept piling higher until mid June.

What seems to have happened is that all stocks listed in Hong Kong started falling while the mainland bubble continued to inflate, whether they were of Hong Kong companies or mainland Chinese ones. It’s not clear why this is.

But what is clear is this. It leaves the shares of FCA trading at even deeper bargain levels than before. Using end of July figures from the fund manager, and adjusting for the subsequent price move from $23.07 to $18.81 at the time of writing, I estimate that FCA has a P/E of just 6.6 and a price-to-book ratio (P/B) of 0.81, plus a very attractive dividend yield of 4.1%. A P/B of less than one means you can buy this basket of companies for less than liquidation value. That’s a great sign of good value.

Now of course those figures are based on past financials. It’s possible that earnings and book value could fall this year across the Chinese companies that FCA invests in. But it still looks highly attractive on those kinds of low multiples.

But caution is required. Chinese stocks – whether traded in Hong Kong or the mainland – look like they could have further to fall. The China shop is still getting smashed up. Best to wait for all the cups and plates to fall and the dust to settle before initiating or adding to positions.

In any case, after such a big bust it will take time for confidence to recover. There are no bulls left in the China shop. So there’s no rush. But at these levels there are clearly bargains to be had in China already. Just so long as you invest the right way, and with patience as always.

Stay tuned OfWealthers,

Rob Marstrand

robmarstrand@ofwealth.com

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Rob is the founder of OfWealth, a service that aims to explain to private investors, in simple terms, how to maximise their investment success in world markets. Before that he spent 15 years working for investment bank UBS, the world’s largest wealth manager and stock trader with headquarters in Switzerland. During that time he was based in London, Zurich and Hong Kong and worked in many countries, especially throughout Asia. After that he was Chief Investment Strategist for the Bonner & Partners Family Office for four years, a project set up by Agora founder Bill Bonner that focuses on successful inter-generational wealth transfer and long term investment. Rob has lived in Buenos Aires, Argentina for the past eight years, which is the perfect place to learn about financial crises.

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