Rise of the China Stock Market
When you are judging the success of your portfolio against benchmarks, which conceptually is a simple exercise, the question soon arises:
1) who are you comparing yourself against?
2) what currency is your benchmark denominated in?
Whether you want to invest there or not, China has had a major rally, and the Chinese Yuan is stable against the US dollar (in the range of 6 Yuan / dollar and 6.4 Yuan / Dollar over the last 3 years) as opposed to other currencies like the Euro and the Japanese Yen which have cratered in dollar terms.
The incredible rise in stocks in Chinese stock prices has mostly gone “under the radar” of US media. Recently they connected the stocks in Hong Kong with stocks on mainland China and not only have prices risen substantially, the same stock trades for different prices in each location. Per this WSJ article
Shares of Chinese companies listed in Hong Kong look like a steal compared with shares of the same companies that are listed in Shanghai. Such stocks on average trade at a 32.89% discount in the former British colony, according to the Hang Seng China AH Premium Index.
Typically, under a concept called “arbitrage”, the price of equivalent items in different markets are narrowed when investors take steps to capture the “easy money” of buying that same good cheaper in a different place. A very simple example is that you can’t have gasoline selling for $4 in one state and $3 in an adjacent state; everyone just crosses the border to buy the cheaper gas until the price differential narrows. Gaps of a couple of percentage even across exchanges is enough for investors to jump in and take advantage; a 32% differential is extreme.
This rally isn’t due to a perception that the economy in China is getting better; in fact it seems to be getting worse. The rally has been enhanced by structural moves that allow more investors into the market (largely retail mainland investors) and lets them buy stock on margin, as well. Per this WSJ article:
Margin lending has more than tripled in the past year to a record 1.7 trillion yuan ($274.6 billion)…The practice isn’t unique to China, where margin debt equals 3.2% of total market capitalization, compared with 2.3% in the U.S. But when compared with the value of stock that is freely traded, making it accessible to ordinary investors, the percentage for China rises because state entities own more than half of the market. Research by Macquarie Securities Group shows China’s margin-debt ratio at 8.2% of the free float. That easily exceeds the peak of 6% reached in the late 1990s in Taiwan, the second-highest level globally in recent years.
Thus if you didn’t have a proportionate share of your portfolio invested in Chinese stocks, you were a “relative” loser, although there are many reasons to believe that this rally isn’t sustainable. This goes back to the original question of how benchmarks are defined.
Individual Stock Moves
In one of the portfolios I follow there have been significant and immediate moves in several of our stocks. These stocks were related to China or the the technology industry.
Linked In (LKND) recently had an earnings call and their stock price plunged by over 20% in one day. The cause of the drop wasn’t the earnings themselves (they beat expectations), it was their “forward guidance”. For stocks with a high price / earnings multiple like Linked In, the market needs to have continued rapid growth to justify the high stock price today. In fact, Linked In currently doesn’t book profits, primarily due to their high amounts of stock based compensation (stock given to executives in lieu of cash). Linked In’s guidance talked about currency headwinds (meaning that if they brought in the same revenues overseas it would “count less” towards net income because of the rise in the US dollar) and also some one time acquisition costs from recent companies they’ve purchased.
Amazon (AMZN) had their last earnings call where they continued to show no profits on a GAAP basis and yet their stock rose 6.8% due to other factors that analysts apparently found compelling. Note that a 6.8% gain for a company the size of Amazon is a large increase in market capitalization (over $10 billion) in a single day.
China Life Insurance ADR (LFC) has almost doubled from around $40 / share to $80 / share as part of the overall China rally discussed above. While a seemingly sound stock this performance gain is not tied to any fundamentals in how the company operates; this growth is tied to the giant overall rally.
Wynn Resorts (WYNN) dropped more than 10% in a single day after earnings were released. Wynn has a property in Macau (China’s only location with legal gambling) and it has been hit hard with a recent crackdown on high-roller gamblers by China’s communist leaders. Note that the scale of gambling in China dwarfs Las Vegas by any measure (total market, amount bet per player, etc…) and thus properties in China have been proportionally more lucrative than their US equivalent. It is not known whether this will be a long term reduction of high rolling gamblers or a short term hit; that depends on inscrutable Chinese government polices. Left to their own devices, it is highly likely that Chinese would continue to gamble at record rates. Wynn also has long running board issues and governance issues as well. At risk is their dividend, which “income investors” price highly in an era of virtually zero yield on debt (without taking on significant risk).
Westpac (ADR) – the Australian bank slightly missed earnings and their stock went down almost 5%, but then recovered a bit and was down 3%. The CEO said that flat earnings won’t be tolerated in a later interview. Unlike those companies with little or no GAAP profits (Amazon, LinkedIn), a company like Westpac won’t usually fall as much with a minor earnings miss because it has a lower P/E ratio and incredible future profit growth isn’t already “baked in” to the stock price.
Seeing large moves in single stocks can be viewed as a sign of a bull market in its last stages. Since we invest for the long term we don’t pull in and out of the market based on short term moves but it is definitely something to consider; stocks with limited earnings and high P/E ratios or tied to giant rallies like is occurring in China today should be on some sort of watch.
Cross posted at Chicago Boyz