Safe profits from the Chinese stock bubble

China has gone stock market crazy. In the past two weeks over 4 million new brokerage accounts have been opened on the mainland. That’s 10 to 20 times the usual rate of openings. And yes, those are just new accounts. The stock market has more than doubled in price over the past year, and Chinese speculators (gamblers?) are desperately trying to get on the bandwagon. Fortunately there’s still a great way to profit without taking the huge risk of investing directly in the new bubble.

The Shanghai Stock Exchange A-share index is up 123% over the past year, after many years of trading sideways. Below is a chart of the index since it’s launch in 1990.

You can clearly see the latest fast run up, and also the last bubble, which popped in 2007. What we can’t tell is how much higher the market could leap before cold, hard reality sets in. It could do on to double again or it could crash next week.

In any case it’s not usually a good idea to get involved in market manias. I know people who learnt that lesson the hard way when they lost a fortune after the dot com technology bubble burst in 2000.

The problem with trying to hitch a ride during speculative frenzies is that you never know when everything will get thrown into reverse gear.

So the question is how to profit from this huge run up in Chinese shares without getting caught by a sudden market implosion. Fortunately, Chinese stock markets have some unique characteristics that make this possible. This is where our opportunity lies.

In broad terms, most of the shares of Chinese companies can be split into two main groups. (There are other lesser categories, but they’re not relevant to this discussion.)

The first group is those that trade on mainland stock markets in the cities of Shanghai and Shenzhen. These are priced in renminbi yuan, the local currency, and are called “A-shares”.

The second group is made up of the shares of mainland Chinese companies that trade in the Chinese territory of Hong Kong. These are know as “H-shares”. They are priced in Hong Kong dollars, a currency that for practical purposes is pegged to the US dollar.

Until recently foreign access to A-shares was extremely restricted. Investment banks and asset managers had to apply for a quota from the regulators. They couldn’t invest more of their own or their customers’ money than the quota allowed. (When I lived in Hong Kong the bank where I worked, UBS, was the very first foreign institution to get assigned a quota.)

These days increased investor flows are being allowed between the mainland and Hong Kong, via something called the “Shanghai-Hong Kong stock connect”. This makes it easier for foreign investors to buy directly into mainland shares and for mainland Chinese investors to buy shares in Hong Kong, although limits remain.

Over time I expect the mainland stock markets to become even more open to foreign money. But until recently it was pretty hard to get in, especially for private investors.

…once you read the fine print you realise that most of them don’t really invest in A-shares at all. Instead they buy “market access products” from big investment banks.

There have been a handful of A-share exchange traded funds (ETFs) for many years. But once you read the fine print you realise that most of them don’t really invest in A-shares at all. Instead they buy “market access products” from big investment banks. In other words they use financial derivatives to get exposure to underlying price moves.

This means that investors in those ETFs are not just taking on market risk, meaning the risk of price swings. They are also taking on counterparty risk, meaning the risk of a default by the bank that issued the derivative. In a highly leveraged world, and having seen so many big banks going bust in 2008 and 2009, we’d do well to avoid that extra layer of risk.

That said, I’ve found a couple of ETFs that now offer direct access to A-shares. These are the (long named) Deutsche X-trackers Harvest CSI 300 China A-shares ETF (NYSE:ASHR) and the Deutsche X-trackers Harvest CSI 500 China A-shares Small Cap ETF (NYSE:ASHS).

Both claim to be the first ETFs to “offer U.S. investors direct access to the China A-share universe”. ASHR is concentrated in shares of larger companies and ASHS invests in smaller companies (“small caps”, short for “small capitalisations”). Both ETFs trade on the New York Stock Exchange (NYSE), so non-US investors can also buy them.

Despite that you should currently avoid both these ETFs, unless you want pure speculations (not recommended). The reason being that both look expensive, meaning they are high risk and unlikely to be good long term investments.

Using latest published figures at the end of March, and taking account of the price rises since then, I estimate that ASHR now has a price-to-book (P/B) ratio of 2.9, which is high. ASHS has a P/B of 4.5, which is extremely high.

By comparison, the already expensive US S&P 500 index currently has a P/B of 2.9, which is the same as ASHR. And at the peak of the dot com bubble – which is to say the largest bubble in the history of stock markets – the S&P 500 index had a P/B just over 5, which is only slightly above the level of ASHS today.

I usually reckon a P/B of around 1.5 is “average” for a country index. The clear conclusion is that Chinese A-shares are already extremely expensive.

None of this is to say that prices of A-shares won’t keep going up substantially from here. But given the very high prices, achieved over a short space of time, they are already well into speculative territory.

Fortunately there is a much less expensive and less risky alternative for those that want to get exposure to the Chinese stock market boom. This comes from buying the H-shares of mainland Chinese companies, traded in Hong Kong.

The big difference is that H-shares are still trading much more cheaply than A-shares, even when they are shares of exactly the same company.

The big difference is that H-shares are still trading much more cheaply than A-shares, even when they are shares of exactly the same company. More and more people are starting to realise this and bidding up the H-share prices to narrow the gap.

One H-share ETF that I like is First Trust China AlphaDEX Fund (NYSE:FCA). Here’s a chart that compares the FCA price performance (in red) with ASHR (blue) and ASHS (yellow) since the middle of 2014 when the A-share market really started to take off.

Chart comparing the FCA price performance with ASHR and ASHS.

You can see straight away that the two A-share ETFs have massively outperformed the H-share ETF. ASHR is up 120% over the period, ASHS is up 112% and FCA is up a more modest 40%.

But FCA has suddenly started playing catch up. At the time of writing it’s up 32% since 11th March. Despite this it’s still relatively cheap.

Using latest published figures from the end of March, and taking account of latest price moves, I estimate FCA has a still modest P/E of 10.3, a reasonable P/B just below 1.5 and a still healthy dividend yield of 2.5%.

This means FCA is likely to be a rewarding long term investment, whether or not the A-share bubble continues to overflow into Hong Kong’s H-shares. But FCA could also rocket upwards in the short term if H-shares continue to play catch up to the overpriced A-shares.

If you want to get exposure to the sudden level of interest in Chinese stocks then I recommend FCA as a relatively safe way to go about it. Leave the gambling to the gamblers, and stick to investing instead.

Stay tuned OfWealthers,

Rob Marstrand

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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.