Foreign investors start to fear China's stock market bubble

Foreign investors are keenly engaging with new opportunities emerging from China's most recent wave of surging stock market prices, although an increasing number of them are warning against the existence of a bubble in this market.

Their key concern relates to the unreasonably high price-to-earnings multiples of those stocks that are leading the growth of China's domestic stock market, the A-share market, explaining that these high multiples are detaching stock prices from fundamental values.

"A lot of these firms already have very high PE multiples, meaning a lot of work needs to be done to perfectly grow into these multiples expectations," says Robert Davis, Senior Portfolio Manager at NN Investment Partners, formerly ING Investment Management.

"The companies could grow fast, but there is a greater risk that they will not grow as fast to justify their current valuations," Davis says.

Davis' views are echoed by Steve Yang, A-share strategist at UBS Securities. "I think the A-share prices have grown extremely fast in recent months, and we certainly can't have such high growth rate every day because at the current rate of growth we'll have 400 percent growth annually, which is unsustainable," Yang says.

To put the skyrocketing A-share prices into perspective, China's main stock index, the Shanghai Composite Index, has doubled since July last year. It rose from around 3,000 points in February to around to 4,400 in April, becoming the fastest growing stock index in the world.

Alei Duan, managing director of London-based financial advisory firm Abridge Capital International, also says that the current high growth in the Chinese A-share market could be a short term trend and seems unlikely to be sustainable in the long term,

"At the moment Chinese share price growth is largely driven by policy and not by the real economy, which means such high prices can't be sustained unless earnings catch up," Duan says. His views are echoed by Ding Yuan, director of CEIBS Research Centre on Globalisation of Chinese Companies, says that he believes China's A-share market will soon experience a correction because the PE multiples of many small-cap growth stocks are quite high, whilst large-cap stocks are at a turning point of earnings growth.

"For the small-cap stocks, the PE multiples are already extremely high. With a tiny drop of growth, there will be a correction," Ding says.

"For the larger companies, the PE ratio is relatively low, but China is now in a period of transition, and if the new model succeeds, the big-cap firms will suffer because they represent the old economy of China," Ding says. Examples of these big-cap firms include Chinese steel companies, cement companies, and highway and real estate.

Yang says that the driver behind A-share in China is the incremental capital going into the stock market. A lot of Chinese mutual funds and hedge funds have raised new capital in the past three months, investors are using leverage to invest, and many Chinese individuals are now directing their savings into the stock market.

For over a decade, foreign institutional investors have been tapping into opportunities in the A-share market through the QFII (Qualified Foreign Institutional Investor) scheme, although the spectrum of opportunities broadened at the end of last year when China introduced the Shanghai-Hong Kong Stock Connect policy.

This policy allows both institutional and retail investors that trade on the Hong Kong's stock markets to purchase a selection of A-shares, and meanwhile allowing investors in the Chinese mainland to buy H-shares. Unlike A-shares, Hong Kong listed H-shares can be freely traded by foreigners.

Yang says the Shanghai-Hong Kong Stock Connect has received great attention from international investors, and marked an important step in the opening up of China's capital markets. It is also healthy for China's capital markets because some of the capital from domestic investors would flow into international stocks as opposed to be concentrated in the A-share market alone.

For international investors like NN Investment Partners, which have traded on the H-share market for years, Shanghai-Hong Kong Stock Connect provides them with a great opportunity to tap into China's A-share market.

But at the same time, Shanghai-Hong Kong Stock Connect has also caused a certain degree of nervousness about the quality and transparency of the A-shares the policy is now giving foreign investors access to, as these A-shares may not necessarily have the same disclosure standards as H-shares.

"There is a feeling that the investor relations of some of the mainland companies are not so sophisticated, and that they have not dealt with overseas investors before. They may not have accounts in English, or may not release their press releases in a timely manner," Davis says.

These concerns, combined with the relatively unfamiliar landscape of the A-share market for foreign investors, have meant that many Western investors are cautious about how they tackle opportunities in China's A-share market.

"The Western investors won't know the companies, and they may not have Mandarin teams to communicate with these companies. But if you talk about the long run, this channel presents a big opportunity for overseas investors to tap into China's growth," Davis says.

Davis' views are echoed by William Fong, Director of Asian Equities at Baring Asset Management. Fong is also manager of the Baring China Select Fund, which invests in A-shares through the QFII route.

Fong says that a key limitation of the Shanghai-Hong Kong Stock Connect policy is the difference in settlement times between Hong Kong traders and traders in the Chinese mainland when buying and selling the same stocks. Settlement time in Hong Kong is T+2, meaning stocks exchange hands two days after a trade is placed, where as in the Chinese mainland it is T+0, meaning same day settlement.

The second limitation of Shanghai-Hong Kong Stock Connect is a daily quota of how much trade can be conducted, meaning it will not accommodate trade volumes above the set limit. Such a limit will affect the potential opportunity this market can bring for international investors.

"We are constantly communicating our needs and concerns with the Hong Kong regulators, and we hope that in the future as Shanghai-Hong Kong Stock Connect becomes more popular, hopefully it will become more effective and transparent in the future, " he says.

Jan Dehn, Head of Research at Ashmore, an investment manager headquartered in London, says that overall opportunities for foreign investment managers to access China's growth are still rather limited.

"Until the markets are opened further, China remains an 'exogenous variable' to most investors. They only look at the growth number and then they deduce what this means for commodity demand and global growth. It is an indirect relationship," Dehn says.

Meanwhile, the price increases of Chinese A-share market has led to a reduction in the number of Chinese firms wishing to list on overseas stock exchanges, Duan says.

"Instead of listing overseas, many Chinese firms are now more willing to list in the domestic market because they would find it easier to raise capital due to positive investor sentiment. The Chinese government’s attempt to encourage stock market growth has also led to an increase in the number of firms they are giving listing approvals,"he says.

Whereas a few years ago many firms need to wait for years before they can list on the A-share market, approval processes are getting quicker now. It seems the Chinese government hopes the growing IPOs can help absorb the surplus of capital on the market, he says.

The optimism seen in Chinese stock markets have also generated more discussions around the issue of China potentially establishing a foreign board to list international firms.

"It may happen in a few years although not immediately. Such a board would give Chinese investors more choices of companies to invest in, and help the Chinese stock market to become more international,"Duan says.

Dehn also says that it makes sense to introduce a foreign board. "There are huge savings in China and the more assets savers have access to the better. Hence, introducing access to foreign stocks in China is a good idea. This will allow global companies to list in China, will improve the status of the Chinese yuan and deepen China’s capital markets further."