Reporting developments in China’s markets to an international audience can be a challenging task. Not only are there language and time zone barriers to consider but also nuanced regulatory and cultural differences that require interpretation. During times of volatility in the onshore markets, events can develop rapidly and reporting on the markets has to come out equally as fast. The volatility in the onshore markets has proliferated a few misconceptions in the media about China’s markets that we believe necessitate further clarification.
Misconception 1: The average stock in China has a Price to Earnings (P/E)1 ratio of 90
In order to dispel the common misconception that all onshore Chinese stocks are overvalued, it is helpful to provide some background information on how the Shanghai and Shenzhen Stock Exchanges are structured. China’s exchanges are organized into a multi-tier system that categorizes listed companies based on specific qualifications. Each tier is designed for enterprises at different stages of growth and offers potential investors different quality and risk profiles.
The top tier is the Main Board of the Shanghai and Shenzhen stock exchanges, which are comprised of large cap stocks that are predominantly state owned enterprises. This is the strictest tier and there are a number of requirements a company must fulfill in order to qualify for the Main Board. One strict requirement is that a company must be profitable for at least three years before listing there.
The next tier is the Small Medium Enterprise (SME), which is limited to only the Shenzhen stock exchange. SME companies are relatively mature in their development and have stable business models, though they do not need to demonstrate three years of prior profitability. The SME tier is primarily composed of manufacturing companies.
The bottom tier is the ChiNext. Like SME, ChiNext is limited to the Shenzhen stock exchange. ChiNext was created to help encourage entrepreneurship, inspire creativity, and popularize innovative business models. The financial requirements to list on ChiNext are relaxed compared to the other two boards.
We can trace the origin of the misconception of overvaluation to the ChiNext board. Today on average the ChiNext has the highest P/E, the highest number of halted or suspended securities, and also the lowest market cap compared to the other tiers2. ChiNext stocks currently have a P/E of 813 versus their five-year average of 58.94, though this is down from their June 12th high of 128.45. Many have used the high valuations in the ChiNext tier as a proxy for the entire Chinese market.
Our fund, the KraneShares Bosera MSCI China A ETF (ticker : KBA) tracks the MSCI China A International Index. This index has 370 constituents and a free float market cap of $900 million6. Our index constituents are primarily large and mid cap Main Board stocks. KBA’s index currently has a P/E of 187, far lower than the average ChiNext P/E of 81.
Misconception 2: The Chinese stock market has stopped trading
There are many regulatory differences between the U.S. and Chinese markets. One difference in China that seems particularly striking to U.S. investors is the ability of Chinese companies to halt or suspend trading. This rule was established in order to prevent insider trading. Whenever a Chinese company has non-public information being released the stock is halted or suspended until that information is disseminated. This can be due to a merger, acquisition, or outside investment by the company. Additionally, if a company trades up or down 10% in one day, the company is suspended from trading for that day.
At the height of the pullback on July 9th, 1442 stocks were halted8, which is a little over half the total number of listed stocks9. The number of halted stocks was featured in most news reports, even though this numerical approach is not a comprehensive measure of the market. We believe a better approach is to look at halted securities by market cap. The stocks that stopped trading never exceeded 30% of the onshore market cap.
Currently, 90%10 of the total 6.83 trillion USD market cap11 in the onshore stock markets is trading. Temporary halts and suspensions make up the remaining 10%12. Claims that China’s stock market has stopped trading disproportionately weigh small cap and ChiNext stocks while failing to consider the importance of large cap stocks in the onshore markets.
During the pullback, the extensive use of margin by Chinese investors was underestimated due to the prevailing use of over-the-counter (OTC) margin. OTC margin is money leant by non-brokerage firms outside of the regulated markets that allowed investors to exceed brokerage margin amounts by upwards of three to five times the money deposited. The extent of the proliferation of OTC margin caught China’s regulators by surprise. In order to eliminate OTC margin without causing a panic, China’s main regulator, the China Securities Regulatory Commission, allowed companies to voluntarily invoke the very common practice of halting or suspending trading to prevent further damage.
Misconception 3: The stock market will derail the Chinese economy
Unlike in the United States, exposure to the stock market in China on a household basis is relatively low. This month Chinese brokerage firm China International Capital Corporation (CICC) issued a report on household finances in China. CICC estimated Chinese households held $8.65 trillion of household deposits, $6.46 trillion of non-equity non-property assets, and a mere $3.59 trillion of stock market investments14. Moreover, according to China economic research firm PRC Macro, less than 5%15 of household savings are invested in the stock market in China. These percentages might explain the low correlation between China’s economic performance and its stock market performance. For example, as China’s markets receded in June, retail sales jumped 10.6% year-over-year the same month16.