The Facts on China’s June Correction

While many press reports highlighted the number of stocks halted they failed to show the size of these companies. According to Bloomberg, As of July 15’s close in China:¹⁰

• 75% (2,211 stocks) are trading, which is 88% of the 6.5 trillion total market cap for the 2951 stocks listed in the onshore exchanges.
• 4% (132) are suspended, representing 4% of market cap.
• 18% (540) are halted, representing 8% of the market cap
• 2% (68) are inactive, representing 0% of the market cap; these companies were scheduled to have initial public offerings but had their IPOs suspended due to a moratorium on new IPOs.

Our portfolios hold predominantly large cap stocks and some mid-cap stocks. Media reports on halted stocks were correct in the number of stocks halted, however, they failed to note the majority of these halts were small or micro cap stocks.

Valuations

We previously stated that we believe investors should avoid small cap stocks due to high valuations. Even today the ChiNext stocks, a segment of the Shenzhen Stock Exchange that represents small cap growth companies, are two standard deviations¹¹ above their average price-to-equity (P/E)¹² of 55 at 86, though down from their June 3 high of 147¹³. The KraneShares Bosera MSCI China A Share ETF (ticker : KBA)’s stocks currently have a forward P/E of 15 while the combined Shanghai and Shenzhen Composite has a P/E of 17 versus its ten-year average of 19¹⁵.

Where do we go from here?

While not of the same magnitude as 2008, there are parallels between China’s recent correction and the U.S. housing crisis. In both cases, standards amongst lenders varied and in many cases decreased over time. Just as no document home mortgages in the U.S. were allowed despite rational thinking, retail investors in onshore China were able to obtain questionable amounts of leverage. Ultimately the U.S. housing market fell and regulators instituted new standards. In China regulators are instituting new policies prohibiting OTC margin. We hope means based testing for the use of margin at brokerage houses is also instituted. Much like how the U.S. housing crisis and subsequent recovery affected certain geographic areas more than other areas, China’s stock market is not apt to see a uniform rise. We believe investors should continue to underweight small cap securities due to high valuations and instead favor large cap stocks, which have returned to their historical average valuations¹⁵.

We believe China will continue to pursue policies that aid its ascent as a global economic power. China is focused on increasing global competitiveness of State Owned Enterprises, we believe these stocks have potential to continue to perform well. Between China’s continued development policies and MSCI’s forthcoming inclusion of onshore equities, we believe investors should seek greater exposure to onshore China. As China evolves from being a retail market dominated by individual investors to an institutional oriented market like that of the United States we believe its markets may continue to grow and perform well.

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1. Data based on MSCI China A International Index as of 7/14/15.
2. Data from World Bank as of 2013. Savings rate: The amount of money, expressed as a percentage or ratio, that one deducts from his/her disposable personal income to set aside as a nest egg or for retirement.
3. U.S. Federal Reserve. “Financial Accounts of the United States: Flow of Funds, Balance Sheets, and Integrated Macroeconomic Accounts” June 11, 2015.
4. Data from World Bank as of 2013.
5. Data from PRC Macro as of 4/28/2015.
6. Margin: The purchase of an asset by paying the margin and borrowing the balance from a bank or broker. Buying on margin refers to the initial or down payment made to the broker for the asset being purchased. The collateral for the funds being borrowed is the marginable securities in the investor’s account. Before buying on margin, an investor needs to open a margin account with the broker.
7. Data from the Shanghai Stock Exchange as of 2012
8. Ai Jingwei. “OTC how to raise capital with the stock market”, Sina Finance, 7/14/2015.
9. Percent change calculated from data reported by Sina Finance (source 7) and People’s Daily, “From The CSRC: The Amount of Off-Balance Sheet Lending is Close to 500 Billion, 15 Billion Forced to Close Shop”, People’s Daily, 6/30/2015.Previous amount of margin was approximately 1.5 trillion RMB between March to May 2015 according to Sina Finance. The current amount of margin is now 0.5 trillion RMB as of 6/30/2015 according to People’s Daily.
10. Data from Bloomberg as of 7/15/2015.
11. Standard Deviation: A measure of the dispersion of a set of data from its mean. The more spread apart the data, the higher the deviation. Standard deviation is calculated as the square root of variance.
12. Price-to-equity: A ratio used to compare a stock’s market value to its book value. It is calculated by dividing the current closing price of the stock by the latest quarter’s book value per share.
13. Data from Bloomberg as of 7/14/2015.
14. Data from Bloomberg as of 7/14/2015.
15. Data from Bloomberg as of 7/14/2015.