Let’s say you could buy a special class of shares in a company with a strong track record of growing revenue and paying dividends, at a 70% discount. The shares are extremely liquid and provide full ownership rights, including a pro-rata share of dividend payments. Would you be interested? You wouldn’t dismiss such an opportunity. At the very least, you’d want more information.
There are numerous Chinese H shares which potentially offer this type of deep value investment opportunity. H shares are listed by Chinese companies incorporated in China which are traded on the Stock Exchange of Hong Kong. Many (but not all) of these companies also have A shares which are listed in China.
Table 1 shows the H share and A share price (converted to HKD using exchange rate data on 17 September) and the median daily turnover over the last 6 months for several H shares in the Fund’s long portfolio.
Table 1: AH Share Discounts
Source: Bloomberg, OQFM
The two most likely reasons why a class of shares would trade at a discount are:
Voting rights: Alphabet, for example, has Class A shares which have voting rights and Class C shares which don’t have voting rights (although somewhat perversely the Class A shares currently trade at a slight discount). In the Nordic region, particularly in Sweden, share classes with different voting rights are common and shareholders exact a discount for the lack of voting rights.
Liquidity: In China, in addition to A shares and H shares, there are also B shares. These are shares listed in China which are traded in foreign currencies (either USD or HKD). They were originally created to allow foreign investors to buy shares in Chinese companies, but with the introduction of the Shanghai-Hong Kong Stock Connect in November 2014, have largely lost their relevance. They are relatively illiquid and this negatively impacts their pricing relative to A shares.
Neither issue is applicable to the A and H shares listed in Table 1. The A shares are more liquid, but H share turnover is still extremely high, and both share classes carry the same voting rights.
Other potential reasons for the pricing discrepancies include:
Trading restrictions: Before the introduction of the stock connect program, Chinese investors couldn’t easily buy shares listed in Hong Kong. China’s strict capital controls ensured that most Chinese investors were restricted to buying A shares. This resulted in too much money chasing too few investment opportunities, exerting upward pressure on share prices. This changed in November 2014 when Chinese investors were allowed to purchase a wide range of HK shares, including all H shares with dual A share listings. In August 2016, the aggregate quota for net purchases was abolished and in May 2018, the daily quota for net purchases was increased from RMB 10.5 billion to RMB 42 billion. In effect there are no longer any restrictions on Chinese investors wanting to buy H shares in companies with dual listings.
Short selling: It is easier to short H shares than A shares. This means there is less downward pressure on A shares from short selling activity. Based on short interest ratios, however, the level of short selling is small relatively to overall trading volumes. The impact of short selling also tends to be exaggerated by people looking for scapegoats. Everyone likes to blame short sellers.
Exchange rate risks: A shares are listed in RMB and H shares are listed in HKD. In theory, HKD depreciation could result in an exchange rate loss for Chinese investors when sale proceeds are converted back to RMB. In practice, the relative share prices will correct for any exchange rate moves given the companies are Chinese and will be valued in RMB. Hence, HKD depreciation will typically exert upward pressure on the H share price (and vice versa). There are costs associated with currency conversions, but they are relatively minor.
Sanctions: Three of the companies in Table 1 are subject to US sanctions. US investors are prohibited from purchasing shares in Semiconductor Manufacturing International, China Communications Construction Co Ltd, and China Telecom and must fully divest their holdings by November 11, 2021. The sanctions apply to both the A and H shares (as well as the ADRs which were listed in the United States), but A share ownership was relatively small. The sanctions were first announced by the Trump administration in November 2020 and we believe most of the forced selling has played out. Further, the sanctions only apply to companies which are supposedly controlled by the Chinese military and most of the companies listed in Table 1 aren’t impacted.
Dividend tax credits: Australia’s imputation system partially explains why Rio Tinto and BHP Billiton – which are dual listed in Australia and London – have typically traded at a premium in Australia. Australian investors are incentivized to buy the Australian listing to receive tax credits attached to dividend payments. This is not an issue for A and H shares.
None of these reasons can be used to justify the extreme share price differentials. However, this does not necessarily mean that the H shares are a great bargain. If the A shares are grossly overvalued – for example, if the true market value of CSC Financial’s A share is HKD $8.06 rather than HKD $38.56, the H shares are properly valued.
This would represent the ultimate rebuttal of the Efficient Market Hypothesis (EMH). Given the A shares are extremely liquid, there are lots of buyers and sellers reviewing all the available information to arrive at what they believe is the fair market price. As we’re practitioners rather than academics and acknowledge that the EMH is flawed, we’ll put this issue aside.
Instead, we’ll focus on company fundamentals. We’ll start with commonly referenced valuation ratios: the one year forward PE (Chart 1), Dividend Yield (Chart 2), and Book Yield (Chart 3) for the companies in Table 1. These ratios are shown for the A shares, not the deeply discounted H shares. It should also be noted that we use more sophisticated value factors in our stock selection process, but these ratios are easier to understand and decipher. For context, we have also included the aggregate ratio values for Chinese A shares, Japanese and Australian equities (weighting each stock by its turnover).
Chart 1: A Share One Year PE Ratios
Source: Bloomberg, OQFM
Chart 2: A Share One Year Forward Dividend Yields
Source: Bloomberg, OQFM
Chart 3: A Share One Year Forward Book Yields
Source: Bloomberg, OQFM
Based on these data, only 688981 CH (Semiconductor Manufacturing International) looks expensive. This company is strategically important to China as it is seen as a potential challenger to TSMC and it has a strong forecast growth profile. Many of the other stocks look relatively cheap and nothing points to excessive valuations.
Currently, the market is rewarding growth stocks, largely due to the impact high growth rates have on company valuations in a low interest rate environment. The following charts show the historical revenue (dark blue) and forecast revenue (light blue) data for each company. We focus on revenue as it is less prone to manipulation than other financial data items.
Charts 4 to 19: Historic and Forecast Revenue Growth
Source: Bloomberg
The revenue growth profiles across the 16 companies vary, but are generally very strong. There is nothing in these data that raises any red flags. Buying these companies at up to a 75% discount does seem like an attractive investment proposition.
Given the A and H shares aren’t fungible – and won’t be for the foreseeable future - there is no guarantee that the extreme H share discounts will narrow. Even if this doesn’t occur, the much higher dividend yield offered by the H shares can result in superior returns. To illustrate: the one year forward dividend yield for China Life Insurance’s A share is 2.6%, while the one year forward dividend yield for the H share is 7.4%. Over 5 years – assuming no change in the H share discount and a constant yield – this equates to an excess return of almost 25%. This also assumes the dividend payments aren’t reinvested; if they were, the excess return would likely be higher.
This is akin to buying a closed-end fund (listed investment company) at a discount to its Net Asset Value (NAV). Even if the discount doesn’t narrow, investors can enjoy a higher dividend yield than would otherwise be the case and hence, all other things being equal, generate a higher total return. (For example, a 4 percent dividend yield at NAV becomes a 5% dividend yield if the shares are purchased at a 20% discount to NAV).
Next, we consider another great advantage of buying H shares at a deep discount: the ability of these companies to raise money extremely cheaply (from an H shareholder’s perspective) by selling A shares. For example, in August China Telecom raised USD 7.3b by issuing A shares at RMB 4.53. At the time the H shares traded at the equivalent of RMB 2.32. The same month, China Mobile – another significant long position in the fund – also filed a prospectus for listing A shares. It plans to raise USD 8.6b at a significant premium to its current H share price, further strengthening its net cash position. Similarly, China Railway Signal & Communication raised approximately RMBD 10.5b in July 2019 and now has a large net cash holding on its balance sheet which equates to more than half of the company’s H share market capitalization. Earlier this year China Suntien Green Energy (600956 CH & 956 HK) also received approval from the China Securities Regulatory Commission for an A share placement. The placement will strengthen the company’s balance sheet while being highly NAV accretive for H shareholders. A win-win outcome!
It is also worth noting that AH discounts vary considerably, both cross-sectionally and through time. The Hang Seng Stock Connect China AH Premium Index provides an easy way to track the price premium (or discount) of A shares relative to H shares (Chart X). Interestingly, there have been periods when A shares, in aggregate, have traded at a discount to H shares. The spike in the index in 2007 and early 2008 occurred during a raging bull market in Chinese equities when the Shanghai Shenzhen CSI 300 Index increased almost 200% over the preceding 12 months (to a level well above the current index value), and well before the start of the stock connect program.
Chart 20: Hang Seng Stock Connect China AH Premium Index
Source: Bloomberg
Although the current A share premium (H share discount) is relatively high, there is currently one A share which trades at a discount to its H share counterpart: China Merchants Bank (600036 CH and 2968 HK). For the large and liquid companies with analyst coverage which are in our investment universe, the current discount/premium ranges from -76.7% to +2.9%.
We’re surprised that extreme H share discounts don’t attract more investor attention. This wasn’t the case when the Shanghai-HK stock connect program was first announced in 2014, but since then investor interest has waned and there is a paucity of broker research and press articles on this topic. There could be another catalyst in the future which rekindles investors’ interest, although full fungibility (such as the ability to convert H shares into A shares) is unlikely to occur within a reasonable investment time horizon.
At OQ Funds Management, we analyse both A and H shares and closely monitor relative share price anomalies. We screen for high quality companies with good growth prospects which A share investors are valuing differently to H share investors. Going back to the question we posed in the first paragraph, we’re definitely interested in buying companies at a discount which have a strong track record of growing revenue and paying dividends. Receiving a much higher dividend yield than would otherwise be the case and benefiting from capital raisings which are highly NAV accretive are icing on the cake.
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