Too hot in Shanghai

China's domestic stock market dropped 9.2% on Tuesday. Why...?

THE CHINESE STOCK MARKET has always been difficult for outsiders to judge. Professionals have often advised overseas investors to buy on Hong Kong rather than Shanghai, using the expertise of Hong Kong to deal with the inscrutability of China.

   That seems particularly good advice at the present time.

   Shanghai has been enjoying a very big boom in the stock market. Prices rose by 130% in 2006 after five years of underperformance. This has driven up equity prices to a price-earnings ratio of 33.

   In the meantime, Hong Kong has remained on a more tranquil p/e ratio of 18. Obviously risk levels are much lower in Hong Kong, which has historically been a less volatile stock exchange than China, with a higher proportion of mature companies.

   The China risk can be measured from the high of the millennium boom in 2000 – when the p/e ratio was in the high 50s – to the low of 2005, when the ratio fell to around 16...a 70% fall in p/e terms.

   Now the Chinese authorities want to bring the Shanghai market under control. There is talk of a forthcoming editorial in the People’s Daily warning readers against putting more money in the stock market. I am not sure his will work.

   Markets do not much like being talked up or talked down, either by bankers or by journalists. J.P.Morgan managed to steer Wall Street through the market panic of 1907, but, after his death, his bank could not prevent the 1929-33 crash.

   In the West, one of the warning signs of a possible crash is a period of intense activity in the Initial Public Offerings market. The Chinese authorities have encouraged the development of the I.P.O. market in order to transfer some of the financing of business from the banks to the stock market. Chinese investors only receive a 2% yield on their bank deposits, and are not allowed to send their money abroad, so I.P.O.s are attractive to them.

   These new issues have been rationed in the past, but the rationing has been eased. This year big Hong Kong companies are looking to China for more favourable issue terms. As a result China may overtake Hong Kong in the total I.P.O. market. This confirms the view that, for the moment, Shanghai is the better market for issuing shares based in the Chinese economy, but Hong Kong is the better market for issuers outright.

   Of course, the China boom may have a further rise ahead of it. No doubt a “value” investor would be cautious, but value investors notoriously miss out the last, and sometimes the best, part of a boom. I remember writing that Wall Street was too high in 1996. Arguably it was, but it went on rising for another four years, which gave my more optimistic friends time both to get in and get out.

   At the beginning of 1996, the p/e on the Shanghai average was only 10; on rising earnings it had reached nearly six times that level by 2000. Long term, I am sure that there is further growth ahead of both the great Asian economies, China and India. In my view, access to China can still best be gained via Hong Kong.

   There are some very high equity prices in India as well, ranging up into the 30s, and even occasionally into the 40s on a price-earnings basis. Yet there are some Indian shares, such as the steel companies, which offer attractive earnings by international standards.

   Of course, steel has always been a cyclical industry. An old broker, who was a friend of mine in the 1950s, who said that he had never made any money out of steel or Brazil. But investors have now made a lot of money out of the growth of the Asian economies.

   At some point they will make a great deal more.