Chinese Stocks: Too Hot to Handle?

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.

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.

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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