Sunday, January 28, 2007

Morgan Stanley's China A-Share Fund: The First of its Kind

Even for US or international investors, it is beneficial to understand more about the Chinese local financial markets (check out here for the A-share H-share Red-chip jargons) because of the rising influence of China in the global economy. The recent dual listing of Industrial and Commercial Bank of China [ICBC] in both the Hong Kong Stock Exchange, as H-share, and the Shanghai Stock Exchange, as A-share (the record breaking largest IPO in world’s history), is just the beginning of this exciting journey.

If you are in US, or in any part of the world, there are, in fact, a number of vehicles in which you can invest and benefit from such a blooming Chinese economy, such as US listed ETFs and ADRs.

There is an interesting article in a recent issue of Caijing magazine (“Caijing”, which means ‘finance’, is a popular and reputable magazine in China that is the Chinese equivalent of Barron’s in US), quoting some numbers which can explain the volatility of the China A-share market and certain large cap stocks listed there.

The total market cap of ICBC is RMB 1956 B (or US$251.7 B), however, because a majority of the shares are held by PRC government associated entities (such as the Ministry of Finance), those shares are effectively not freely traded. The real free floated market cap of it’s A-share is of RMB 42B, or only 2% of the total market cap.

What does RMB 42B means in China? Lets take a look at the current market situation in China. Recently Harvest Fund (a local PRC fund house) launched a mutual fund, the size of which is RMB 40B. This was fully subscribed in just one day and was times overly subscribed by local Chinese retail investors. This explains the high volatility of those red hot A-share stocks in China.

ICBC has also became the 2nd largest bank globally in terms of market cap, and when we compare the average P/E, P/B of top 5 banks globally vs. that of ICBC, we may want to think rethink what it really mean being the 2nd largest bank in the world:

top 5 banks vs icbc

Now lets look at another set of interesting numbers about the constituents of the Shanghai Stock Exchange Composite Index:

Shanghai exchange composite index

The Shanghai Stock Exchange Composite Index is computed using total market cap instead of "free floated" market cap. Since a majority of Band of China, ICBC and China Life shares are practically not free floated (though technically they are), this leveraging effect has given these three stocks such a high percentage influence to the index, while only a small percentage of those shares are freely traded in the exchange.

Do not misunderstand my presentation of all the above numbers. I am very bullish about the Chinese economy and I am very confident with the sustainability of the ~10% annual GDP growth.

The above abnormality will be corrected when the more heavy weight high quality H-shares (such as China Mobile, China Telecom, Petro China) return to the local Shanghai market. Though Hong Kong has been part of China since 1997, with the 1-country-2-systems policy they are really two different jurisdictions; H-share and A-share are practically two different markets, though the underlying assets of each A-share and H-share are the same. And there can be no arbitrage opportunity as of today because foreigners (HK people are defined as foreigner in this aspect) are not allowed to trade A-share unless they have QFII quota (Qualified Foreign Institutional Investor).

It’s not a matter of whether those companies will return to Shanghai or not, it’s just about when. The PRC authorities are already investigating various approaches; one of them is by means of CDR (Chinese Depository Receipt, similar to ADR listed in US).

Back to the ETF vehicles through which we can benefit from the blooming Chinese economy: I find Morgan Stanley's China A Share Fund (CAF) particularly an interesting.

Out of the many other China related ETF listed in US, such as iShares FTSE/Xinhua China 25 Index (FXI) , the underlying assets of all of them are H-share/Red Chip shares listed in Hong Kong, because they don’t have QFII quotas and hence unable to invest in A-shares. This has restricted those ETFs to mimic H-share based indices, only without the freedom to really pick good individual stocks listed in China.

The situation has changed since Morgan Stanley launched CAF, which is the 1st US listed ETF with a capability to invest directly in A-shares. [Morgan Stanley has secured about US230M QFII quota for the CAF fund]

Here are CAF's top-10 holdings as of the end of December 2006:

CAF top ten holdings

I am happy to see that ICBC or BOC are not on the list; otherwise I would have doubt how this supposedly actively managed fund differs from the other passive index funds. Particularly there is one holding looks interesting to me: Zhengzhou Yutong, a PRC local commercial bus manufacturer. Although I am based in Hong Kong. and not in China, I can still observe that there a lot of such Yutong buses deployed in HK carrying tourist from PRC. With the increasing personal income level of local PRC citizens, tourism is another beneficiary of the blooming Chinese economy. By applying Peter Lynch’s investment approach, this looks like an attractive company and the CAF fund manager is doing his job. You will not find stocks like Yutong in FXI, because such companies are only listed in A-share market; funds with no QFII are not able to buy those assets. That’s the reason I would prefer CAF than FXI.