Why Shanghai and Hong Kong are the world's cheapest sharemarket 'bubbles'

A 25 per cent surge in Hong Kong-listed shares has investors worried the market is running too hot. Photo: Bloomberg

When the price of any market doubles in the space of 12 months (like the Shanghai Stock Exchange's benchmark index), or jumps by almost a quarter in a matter of weeks (like its Hong Kong equivalent), the temptation is to write them off in one word: "bubble".

But can a sharemarket trading on a price-to-earnings ratio of 10 be considered to be in a bubble? That's the Hong Kong-listed stocks in both the Hang Seng Index and the Hong Kong China Enterprises index.

If the answer is "yes", then Mammon help local investors who are ploughing money into the Australian sharemarket, which trades on a nose-bleeding forward P/E of 16.

Ah yes, you say, but look at the mainland Chinese sharemarkets. That's where the full weight of irrational exuberance is on display. The Shanghai Composite Index now trades at 18 times estimated earnings for this calendar year, on Bloomberg data. Once again, the move has been dramatic, but the resulting valuation less so. The Shanghai index is about the same as the S&P 500 index, but well below the multiple of 28 investors are paying for the US Russell 2000 index.

"On an absolute basis, the valuations of these markets are not expensive, nor are they if you benchmark their P/Es against the US, Japan, Australia, or even Europe," Joseph Lai, who manages Platinum Investment Management's Asia Fund, says.

HSBC's head of Asia ex-Japan equity strategy Herald van der Linde doesn't see a bubble in Chinese shares, also pointing to valuations that have expanded fast but from very low levels. He remains "overweight" China, although he does add that some air might come out of the stocks that have run particularly hard.

"We like the financials sectors, banks and property companies, on the back of the lower interest rates we see in China," van der Linde says. "We also see infrastructure projects, such as those happening on the old silk road, benefiting infrastructure companies in China."

New money 

What has been particularly exercising pundits is the fact that the surges on the Shanghai and Shenzhen exchanges, and more recently in Hong Kong, are the result of a wave of new money from individual Chinese investors who look to be punting on a government-sanctioned boom in share prices, and often doing so on borrowed money.

"In our summer last year we started seeing in the Chinese media almost educational pieces encouraging mainland investors to get back into the sharemarket," Catherine Yeung, a Hong-Kong based investment director at Fidelity Worldwide Investment, says.

But this also needs to be put in context. After years of losing money, "mum and dad" investors in China had largely abandoned the sharemarket, often in favour of the property market. Exchanges in Shanghai, Shenzhen and Hong Kong essentially stagnated from late 2011 to 2014, as the chart shows.

Then in November the Chinese government announced reforms that made it easier for foreigners to invest in the Shanghai exchange and for mainlanders to buy Hong Kong-listed mainland businesses.

About the same time, policymakers began stepping up measures designed to stimulate a flagging economy. Chinese mums and dads began starting to take notice of the sharemarket, which was showing signs of life for the first time in years. They began to pile in.

The crescendo looks to have been reached in March, when retail Chinese investors opened about 4.2 million brokerage accounts, triple the number in February and taking the total number of new accounts this year to about 8 million. That's more than were opened in 2012 and 2013 combined, Fidelity's Yeung says.

A change of rules around Easter that gave Chinese mainland fund managers more access to Hong Kong-listed shares sparked a buying frenzy, as southbound money poured into the island's sharemarket and local investors jumped in to front-run the flow of money.

Daily turnover

The average daily turnover on the Hong Kong stock exchange tripled in short order, from an average of $HK87 billion ($14.47 billion) to $HK231 billion between April 8 and April 21.

More recently, regulators announced measures to rein in margin lending, which has been taken up enthusiastically by mainland investors.

"The ultimate aim of the government is to create a slow bull market rally," Yeung says. "It's very hard to change the behaviour of an investor who is set to go two ways – either a strong rally or sharp correction. That is the conundrum."

Lai says there has been some particular exuberance among Chinese small caps, but the larger names remain good value.

He points to a name like SAIC Motor Corporation, a joint venture between Volkswagen and General Motors and "a big company that sell millions of cars in China". The Hong Kong-listed stock is up 86 per cent over the past year, but trades on a P/E of 9.5. Or the giant China Mobile, which is the dominant mobile telco provider in China, with more than 800 million subscribers. It trades on eight times cash flow, Lai says, and that's after having jumped 65 per cent over the past 12 months.

A bet on China is also a bet that the government can continue to reform and rebalance the country's economy and steer it towards a more sustainable future.

"If economic reforms can continue to progress towards a more equitable and ecologically sound outcome, and the country can allocate capital better, then I think the market today is very cheap," Lai says. But he warns: "If the reform stalls, then we would have to reassess the market and our investment".

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