Seizing Value-Investing Opportunities in the Shenzhen-Hong Kong Stock Connect

The Shenzhen-Hong Kong Stock Connect (SZHK) scheme is expected to roll out by the end of this year. Peter Tsang, the famed financial commentator and follower of legendary commodities-investment guru Jim Rogers, believes that the doctrines of value investing can help investors capture opportunities under the SZHK scheme.

As an apprentice of Jim Rogers and a value-investing devotee, Tsang reminds investors of the perils of a herd mentality: "While many financial pundits are quick to conclude that the Shenzhen stock market is a sweet spot for Hong Kong investors because it is rich in new-economy concept stocks and covers sectors we don't have in Hong Kong, we must not forget the principles of value investing." Value investing emphasises the intrinsic value of companies, which is determined by assessing a mix of fundamental factors including earnings growth, dividend distribution capabilities and net asset value. If the intrinsic value is higher than the current price, it may signal more room for potential changes in price, Tsang says.

The Methodology of Value Investing is also Applicable to Shenzhen Stocks

Some market analysts have claimed that the approach of analysing stocks in value investing is not applicable to the Mainland stock market. Tsang, however, has an opposing view: "I believe that the senior policymakers in China have been steadfast in their reform efforts to open up the market in order to usher in fair and open competition. As long as this policy direction stays unchanged, value investors who invest only in high-quality companies will certainly be likely to earn a reasonable return."

"Now we have the Shanghai-Hong Kong Stock Connect (SHHK) and the SZHK, we can give the schemes a new name: the China-Hong Kong Stock Connect," Tsang says light-heartedly. With the launch of the SZHK, the abolition of investment quotas and the expanding scope of eligible stocks, the Mainland stock market is opening up its door even further to Hong Kong and foreign investors. This is not only a critical step in the market reform roadmap, but also a potential trigger to start a re-rating process in certain Hong Kong stocks that are trading at low valuations.

After its launch, the SHHK scheme was well received during the stock market rally from the end of 2014 to mid-2015 and in recent months, albeit occasionally with thin transaction volumes. The SHHK mainly covers blue chips and large-cap stocks, which retail investors in general are not interested in; on the other hand, fund houses can funnel their investments through QDII or QFII schemes, so market responses for the SHHK may sometimes be lukewarm, Tsang explains. In contrast, the SZHK has wider coverage over small- and mid-cap stocks, hence the new scheme is expected to open up new investment channels that can enhance liquidity in both the SZHK markets. It may enjoy a warmer reception than the SHHK, Tsang says.

Furthermore, the small- and mid-cap stocks selected by the Shenzhen Stock Exchange and the Hong Kong Stock Exchange to be included in the Stock Connect have larger market cap than peers in the same class. This can reduce investment risks borne by investors under the scheme. It also reflects the authorities' intention to educate investors. Tsang believes that, if the stock exchanges exert greater effort to promote the scheme, it will encourage more southbound capital to flow into Hong Kong's quality stocks. As the Mainland market entails a larger pool of capital than the Hong Kong market, channeling funds to Hong Kong is set to beef up the transaction volume and improve valuations in Hong Kong stocks, he adds.

On stock selection, Tsang remarks: "We should consider if the revenue and profit of an enterprise are able to expand as its business grows, and whether it is attractively priced relative to its net asset value. The Shenzhen stock market is filled with ‘growth stocks' trading at staggering price-to-earnings ratios and price-to-book ratios. A case in point is a Chinese tech stock that saw its stock price nearly doubled in May 2015. But the strong rally was followed by an equally dramatic slump. The current price is down 25% from last year's peak."

Tsang advises investors that, if they attempt to invest in "new economy" sectors in China, they should first gain a thorough understanding of the sectors. For example, to invest in biotech companies, investors should investigate whether the firms in question have new drugs in the pipeline, and whether the new drugs can bring in considerable profits.

Consider A-H Premium and Fundamental Factors

Hong Kong stocks in general are trading at lower valuations than their Chinese counterparts. For the same stocks dual-listed in both markets, A shares may be trading at a premium over their respective H shares. Can this help to drive capital southward? Tsang thinks that, given the same voting rights, a stock should be trading at the same price across different markets. However, some A shares are trading at a premium because they have less outstanding issues in circulation; the larger pool of capital in the Mainland market coupled with previous RMB appreciation expectations also led to the valuation premium in A shares. The premium may still present after the launch of the SHHK.

Tsang expects the A-H premium to gradually tighten under expectations of RMB depreciation and the launch of the SZHK. Nevertheless, he cautions that investors should not impetuously invest in H shares that are trading at a large discount to their respective A shares. "Although some H shares are trading at a discounted price when compared to their A shares, this does not necessarily mean they are trading at a low valuation. They cost less than their A-share peers but can still be expensive. To illustrate this with an example, assume that you are searching for a hotel room for your overseas trip and come across an ordinary hotel room that costs $500 per night. This appears cheap when you compare it to the $1,000 per night price tag of a room with a sea view. However, by paying more, you will receive much more pleasure than if you stayed in an ordinary room. So some people may think it is worthwhile to pay the premium." Tsang expects that Mainland investors who have a long-term perspective will wait for the A-H premium to narrow. If this is true, fundamentally strong H shares may have a better chance to outperform when the A-H valuation gap closes. The price trends of Chinese banking stocks and insurer stocks have demonstrated this point well - the blue chips in these sectors have seen their A-H price gaps further narrowed when news about the SZHK came out.

Tsang suggested to consider several well-known enterprises listed in Hong Kong. "Mainland investors are more familiar with these brands, and well-known companies are better positioned in a speculative market. In addition, investors should focus on sectors in which low entry points are present. For example, if you are optimistic that the stock of a well-known property developer will perform well, but the current home-buying restrictions implemented by the government have led to a price correction in the stock, then you may evaluate the company's fundamental factors first and then consider to ride on the correction to invest in the stock at a low price. You should try to find out if the developer has refrained from bidding for overpriced land, or if it has achieved an outstanding pre-sale record within the year. Lastly, Tsang concludes by saying that, no matter which stock market you plan to invest in, be it Shenzhen or Hong Kong, "protect capital first before adding value to your investment" is always the essence of value investing.

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