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Article / 08 July 2015 at 0:15 GMT

Quality will out after the A-Share rout

China Watcher / Shanghai
China
  • Given the 30% drop in the Shanghai Composite, US-listed companies may reconsider their planned re-listing on the mainland
  • Unlike the West, China will do whatever it takes to stave off social unrest
  • US-listed Chinese shares are by and large cheaper than their US equivalents
  • For the vast majority of US-listed Chinese firms, I wouldn’t recommend taking a long position at this current time

By Neil Flynn

The rally seen in domestic equity markets over the past 12 months has seen growing interest in investing in China. But fueled by leverage, indices have fallen as the government cracked down on margin trading in order to create a more sustainable rally. However, the problem that it now faces is that it is having trouble arresting the decline.

To its credit, the government has tried to put a stop to the declining equity markets, through monetary easing, a partial retraction of its crackdown on margin trading, a ban on new initial public offerings, and a commitment from major brokerages to not sell equities when the index is trading below 4,500 - a level that a month ago naïve traders didn’t expect to see for a long while.

However, it has been of little value to the market, which seems to be waiting for a much larger action from the government. Millions of new traders opened brokerage accounts at the peak of the rally, investing all of their money, and quite often leveraged by illegal loan companies, but they now stand to lose significant amounts of money if the index stays this low.

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 A-Share hysteria: What would Buddha have counselled in such times? Photo: iStock

The key difference between China and western developed nations is that China will do whatever it takes to stave off social unrest. If equities remain this low and investors begin to take their losses, then social unrest will grow quickly across the country, and from the government’s point of view, it is imperative that this is avoided.

More than 7000 miles away in New York, US-listed Chinese firms are suffering from the concerns back home, as they are enduring big losses everyday. Despite government action on a weekly basis, it is being ignored by western investors, who themselves are leveraging concerns over China on the more immediate worries over Greece.

Even after the heavy losses seen on Monday, Chinese firms have endured another heavy down day on Tuesday. As of mid-morning New York time, Chinese tech names have suffered major losses on the back of no substantial news. In fact, it seems that investors are simply cutting their exposure to Chinese equities until there is a level of stability in the domestic A-share market.

However, these substantial losses will cause opportunities in the market, because the P/E and P/S ratios are by and large below those of their US equivalents. Firms such as Qihoo, Jumei and VIPshop are large firms with strong earnings and positive near term prospects going into earnings season, but are falling heavily, and it poses the question of when is the right time to buy a quality firm during a rout?

Tuesday morning saw Chinese equities suffer major declines

US listed Chinese equities continue to fall
Source: Seeking Alpha

The concept of buying equities as they’re falling in order to get a cheaper price is correctly compared to trying to catch a falling knife. For the vast majority of US-listed Chinese equities, it is certainly the case, and investors would need to have a high risk tolerance in order to take a long position.

But there are certain firms that have being enduring losses, not because they are overpriced, but because they just happen to be from China. Alibaba and Baidu have suffered losses, but not nearly to the same extent as smaller firms. Alibaba has fallen 15% since the start of June, whilst Baidu has fallen 8.8% over the same period and 12.3% since June 22.

Part of the reason for major declines is likely to be the wave of privatisation bids from US-listed Chinese companies, which have the intention to re-list in China where valuations are higher. Approximately half of the firms in the list above are considering a management led buyout, whilst the other half certainly fit the criteria to do so.

With falling valuations in China, investors could have concerns about whether management may reconsider their planned re-listing in the mainland, and that the management led buyout bids are funded through capital invested in China.

Given that the Shanghai Composite has fallen over 30% since most of the outstanding privatisation bids were made, it’s a genuine concern to investors, and I would not be surprised to see half the bids being retracted. However, this doesn’t apply to Baidu and Alibaba, because neither would consider de-listing from the US.

Chinese firms may be generally undervalued on Wall Street, but Baidu is a well-respected company in the US, and its earnings are treated fairly by investors, unlike rival Qihoo, which proposed a $10 billon management buyout bid in June. Likewise, Alibaba held the largest IPO in US history nine months ago, and its presence in the US will help to expand its business outside of China.

For the vast majority of US-listed Chinese firms, I wouldn’t recommend taking a long position at this current time, because the volatility is simply too high. However, the case for major firms such as Alibaba and Baidu becomes more attractive as the rout continues.

Both firms will release their calendar second quarter earnings in August, and the panic over China should have subsided by then. The low prices seen at the moment could represent an attractive buying point for some investors.


-- Edited by Adam Courtenay

Neil Flynn is a portfolio manager at Alcuin Asset Management. Follow Neil or post your comment below to engage with Saxo Bank's social trading platform.



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