Price-to-earnings multiples that lead Chinese stock market seen as too high

Foreign investors are keenly engaging with new opportunities emerging from China's most recent wave of surging stock market prices, although an increasing number of them are cautioning against a bubble in this market.

Their main concern relates to what they regard as the unreasonably high price-to-earnings multiples of those stocks that are leading the growth of China's domestic stock market, the A-share market. With these high multiples, stock prices are becoming divorced from fundamental values, they say.

"A lot of these firms already have very high PE multiples, meaning a lot of work needs to be done to perfectly grow into these multiples expectations,"says Robert Davis, senior portfolio manager at NN Investment Partners, formerly ING Investment Management.

"The companies could grow fast, but there is a greater risk that they will not grow as fast to justify their current valuations."

Davis' views are echoed by Steve Yang, A-share strategist at UBS Securities. "I think the A-share prices have grown extremely fast in recent months, and we certainly can't have such a high growth rate every day because at the current rate of growth we'll have 400 percent growth annually, which is not sustainable," Yang says.

To put the skyrocketing A-share prices into perspective, China's main stock index, the Shanghai Composite, has doubled since last July. It rose from about 3,000 points in February to about 4,400 last month, becoming the fastest growing stock index in the world.

Alei Duan, managing director of Abridge Capital International, a financial adviser in London, says the current high growth in the Chinese A-share market may be a short-term trend and seems to be unsustainable in the long term.

"At the moment Chinese share price growth is largely driven by policy and not by the real economy, which means such high prices can't be sustained unless earnings catch up," Duan says.

His views are echoed by Ding Yuan, director of the CEIBS Research Centre on Globalisation of Chinese Companies, who says that China's A-share market is likely to experience a correction soon because the PE multiples of many small-cap growth stocks are high, while large-cap stocks are at a turning point of earnings growth.

"For the small-cap stocks, the PE multiples are already extremely high," Ding says. "With a tiny drop of growth there will be a correction. For the larger companies, the PE ratio is relatively low, but China is now in a period of transition, and if the new model succeeds, the big-cap firms will suffer because they represent the old economy of China."

For over a decade, foreign institutional investors have been tapping into opportunities in the A-share market through the Qualified Foreign Institutional Investor (QFII) scheme, although the spectrum of opportunities broadened at the end of last year when China introduced the Shanghai-Hong Kong Stock Connect policy.

This policy allows both institutional and retail investors that trade on Hong Kong's stock markets to buy a selection of A-shares, and investors in the Chinese mainland to buy H-shares. Unlike A-shares, Hong Kong listed H-shares can be freely traded by non-Chinese.

Despite the new opportunities Shanghai-Hong Kong Stock Connect has opened up to foreign investors, this new investment route has limitations, says William Fong, director of Asian equities at Baring Asset Management. Fong is also manager of the Baring China Select Fund, which invests in A-shares through the QFII route.

Fong says that a key limitation is the difference in settlement times between Hong Kong traders and those on the Chinese mainland when buying and selling the same stocks. Settlement time in Hong Kong is T+2, meaning stocks exchange hands two days after a trade is placed, but in the Chinese mainland it is T+0, meaning same-day settlement.

The second limitation of Shanghai-Hong Kong Stock Connect is a daily quota of how much trade can be conducted, meaning it does not accommodate trade volumes above the set limit. Such a limit will affect the potential opportunity this market can bring for international investors.

Jan Dehn, head of research at Ashmore, an investment manager whose headquarters are in London, says that overall opportunities for foreign investment managers to access China's growth are still rather limited.

cecily.liu@chinadaily.com.cn