Chinese Stocks: Too Hot to Handle?

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Chinese stocks, especially IPO stocks, are as hot as they can be, thanks to the growing appetite among investors who look Chinese stocks as a proxy to tap into Chinese economy, which is still growing at a sizzling 11.5% in the latest quarter despite measures introduced by the government to cool it off. And an increasing number of Chinese companies are choosing to sell their shares on foreign exchanges such as NYSE/NASDAQ and HKSE. These days, it’s not unusual to see the price of a Chinese stock, whether it’s listed on domestic or foreign markets, skyrocketing in its first day of trading, sometimes more than doubled, as noted in a recent Forbes article, Sell China Before The Games

Recently, The Wall Street Journal reported that the average first-day return for Chinese initial public offerings (IPOs) in 2007 has been 192%.

Chinese stock markets

However, from what I read, the debate right now seems to be focusing more on Chinese domestic markets than stocks traded overseas and the concern is whether there’s a bubble waiting to burst. Arguments for the bubble are made based on stock valuations and the magnitude that Chinese stock index, particular the Shanghai Composite Index, has risen in the recent couple of years.

Analogy has been drawn between the Shanghai index and the NASDAQ index in the late 90s. According to the same Forbes article, the Shanghai Composite Index took a little over 2 years to gain 500% from below 1,000 in June 2005 to above 6,000, while the NSADAQ returned 240% in less than two years to reach the record of 5,000 in March 2000. On the valuation side, the article cited a recent UBS report that the Shanghai index has a P/E ratio of 68, identical to the NASDAQ’s P/E right before the tech bubble burst.

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Granted, the two indices look a lot similar on charts, but I do feel that valuation alone may not tell the whole story. During the go-go days of the NASDAQ, stocks of companies that had no means to make profits what so ever could be traded at 50 times projected earnings, as long as they had the right concept to make money. Many Chinese companies that started to offer shares to the public, however, do have solid businesses, especially the state-own companies (such as PetroChina, Sinopec, China Mobile, China Life Insurance, Huaneng Power, etc.) that have dominate positions in the nation’s economy. As the Chinese government encourages domestic companies to list in Shanghai instead of New York as a way to diversify the country massive savings (total more than $7 trillion dollars in private and official savings), there are reasons to believe that the Shanghai index could go even higher (PetroChina will start to offer A-shares in Shanghai next month which attracted more than $440 billion dollars). And China is still a nation of savings, not consumption.

And by comparison, Chinese stock markets, which have less than 20 years of history, are still quite small. According to Wikipedia figures, the total market capitalization of two Chinese stock exchanges is about $3 trillion dollars, while the NYSE and the NASDAQ combined have nearly $24 trillion dollars in market value. Yet China has a 2006 nominal GDP of $2.6 trillion dollars compared to the US’s $13.2 trillion dollars. The Chinese stock markets still have lot of room to grow.

Chinese stocks traded in the US

That average 192% return, however, is for stocks in domestic markets. For stocks traded here in US, the performance is different. According to data from IPOHome.com, the returns of Chinese IPO stocks in 2007 are shown in the following table. While many have posted double- even triple-digit returns since IPO, quite a few actually dropped below their IPO prices.

Name Symbol IPO Date IPO Price Current Price Gain
3SBio Inc. SSRX 2/6/07 $16.00 $16.02 0.1%
Acorn International ATV 5/2/07 $15.50 $17.99 16.1%
China Digital TV STV 10/4/07 $16.00 $38.86 142.9%
China Sunergy CSUN 5/16/07 $11.00 $9.13 -17.0%
E-House Holdings EJ 8/7/07 $13.80 $34.00 146.4%
Fuqi International FUQI 10/22/07 $9.00 $8.50 -5.6%
JA Solar Holdings JASO 2/6/07 $15.00 $56.06 273.7%
LDK Solar LDK 5/31/07 $27.00 $37.89 40.3%
Longtop Financial Tech. LFT 10/23/07 $17.50 $29.95 71.1%
Noah Education Holdings NED 10/18/07 $14.00 $18.60 32.9%
Perfect World PWRD 7/25/07 $16.00 $28.87 80.4%
Qiao Xing Mobile Comm. QXM 5/2/07 $12.00 $11.61 -3.3%
Simcere Pharmaceutical SCR 4/19/07 $14.50 $15.99 10.3%
Spreadtrum Comm. SPRD 6/26/07 $14.00 $12.50 -10.7%
Tongjitang Chinese Medicines TCM 3/15/07 $10.00 $11.40 14.0%
WuXi PharmaTech WX 8/8/07 $14.00 $39.35 181.1%
Xinhua Finance Media XFML 3/8/07 $13.00 $6.65 -48.8%
Yingli Green Energy YGE 6/7/07 $11.00 $34.39 212.6%

After the sell-off of Chinese stocks in late February which also sent the Dow 416 points south, there were many discussions on the risks of investing in China, but since then Chinese stocks have been growing at a even fast pace. The risks are certainly there, so are the opportunities for people who are willing to take them. The Chinese economy is growing at 11+% annually while the growth rate of the US is about 3%. That alone is worth some premium. For investors who invest in Chinese stocks, what they are looking for is growth, as pointed out by a recent article, A Taste of China for the Bold Buyer:

Even where stocks are pricey—Jason Hsu, principal director for research and investment management at Research Affiliates, says U.S.-listed Chinese stocks trade at an overall P/E ratio of 60—those valuations represent high growth expectations for earnings. But, Hsu adds, the risk to investors is also high. Then again, says Dennis Stattman, a portfolio manager for BlackRock Global Allocation Fund, “you don’t invest in China for safety. You invest in China for growth.”

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10 Responses to “Chinese Stocks: Too Hot to Handle?”

  1. KMC |  Oct 29, 2007 at 4:42 pm

    I think you don’t need to go any further for an explanation than ‘transparency.’

    If I understand the situation correctly, you pretty much have to take on faith that what the company/government is telling you the revenue and profits are for these companies is the truth.

    I think that’s less true for stocks sold in the US.

    Am I correct in this interpretation?

  2. The Dividend Guy |  Oct 29, 2007 at 11:41 pm

    I also have trouble investing on my own in China – there does not appear to be much transparency. I may be wrong, but I suspect these companies are heavily influenced by governments and that just does not sit right with me. I even have trouble investing in Bombardier in Canada because of the federal money that company receives.

    I will stick with my Global Index Fund! Interest post though…

    The Dividend Guy

  3. Money Blue Book |  Oct 30, 2007 at 5:16 pm

    Well I’m nearly 65% invested in the China and Southeast Asian markets so obviously I don’t think it’s too hot to handle. I was in before the recent boom so I’m definitely in for long haul growth. China truly has great upside…and this is not just dotcom style hype…

    Transparency is still a major issue and China will have to address this in the future. I hope the changes are gradual rather than drastic however.
    -Raymond

  4. FourPillars |  Nov 03, 2007 at 12:04 pm

    Hi there – great post.

    It’s tough to know whether to invest in hot economies and to what degree.

    I actually wrote on my feelings about a Chinese mutual fund that I briefly owned.

    Mike

    http://www.four-pillars.ca/2007/07/03/chasing-china/#more-50

  5. rstlne |  Nov 05, 2007 at 2:08 pm

    I had one Chinese stock, LJ International. I picked it way back when it was a reasonably-valued microcap. This year, it exploded upwards. I sold half my stake in it while it was up nearly 200% year-to-date. I sold the rest of it later in the year when they were late in reporting their financials. It was a tidy profit but definitely risky given their lax approach to accounting.

  6. Shadox |  Nov 17, 2007 at 6:43 am

    Money Blue Book – you may be making a bucket load of money right now, and you may cotinue to make bucket loads of money for years to come, but your investment strategy is extremely risky. By your description it seems to me that your portfolio is not nearly as diversified as it should be. Good luck to you!

    I don’t know whether the Chinese stock market will hold up, continue to climb or drop like a ton a lead, but I do know this: stock markets rarely maintain a straight line trajectory. Stock markets that rise dramatically over a certain period, have a nasty habit of reversing course or retrenching for long periods of time. The bottom line is that investing in China – and other emerging markets – is the hot fad of the moment. Hot investment trends should be avoided like the plague. I have a recent post on the subject, it’s called “Fashion Belongs in Milan”. You can look it up on my blog if interested.