CAF: If Money Flows into Mainland China, It's Where You'll Want to Be

By Daniel Harrison

Matt Hougan’s recent article on Morgan Stanley’s China A-Share closed-end fund (CAF) brings some much-overlooked discussion to the table of Chinese mainland-listed share valuations, and to what extent they are overpriced.

Matt points out that as a closed-end fund, CAF currently trades at a premium. In addition, the Shanghai-listed Chinese A-shares that the fund invests in also trade at a premium, compared with equivalent shares listed abroad. Add it together and CAF ends up being 18 percent more expensive than a basket of similar Chinese company shares listed in Hong Kong or New York.

In other words, you are paying nearly a fifth extra for the hope that other international investors will, over time, attempt to flock to Shanghai. (Read the whole story here.)

For Matt, that’s too high a price for what seems like an outright gamble. There are few who would disagree.

The A-share premium ultimately works like initial repayments in a Ponzi scheme. If China opens up its domestic exchange to international investors, that premium will likely collapse.

But that might not happen for a long, long time. And in the meantime, the premium depends on what price investors in the domestic markets are willing to pay each other. As such, that’s the way I think you have to judge any investment in CAF.

I don’t think it’s very useful to use a year-to-date, or even 12-month, time horizon for CAF. This was a period of dynamic readjustment in global equity prices, where markets were more or less insularly focused.

Instead, mark the time horizon for the fund back five years, and compare the results with other China-related ETFs. When you do that, you can see that CAF easily beats competing ETFs such as GXC and FXI in terms of percentage-point gains.

Indeed, up until the beginning of the market fallout in late 2007, CAF was more than three times ahead of these two.

This was a period when China was implementing all sorts of new foreign-investor-based programs; there was also plenty of cheap money to channel into them. That hasn’t been the case this year.

Of China’s various qualified foreign institutional investor (QFII) quotas, only one bank (UBS) was at its $800 million maximum investment limit earlier this year (it has recently been expanded to $1.2 billion). The rest have around $400 million or less invested in the mainland through the program.

Placing a bet on CAF then is not just placing a bet on China; it’s placing a bet that foreign institutions will throw more cash China’s way. Judging from all the various trading notes I’ve seen recently citing emerging markets as the big profit area going forward, I think that’s a plausible scenario.

As banks become better capitalized again, and if China decides to keep most of its domestic market closed to foreign investors (extremely likely), there will be all sorts of creative ways in which firms try to get in the back door. That, in turn, will mean mainland equity prices begin to skyrocket.

So if you think loose global monetary policy will end up channeling much of today’s greenbacks eastward, CAF could well present a viable investment opportunity right now.

Original post

Comments

[huangthomas:]

Yes, gem is hot right now, so are stocks of large banks and real estate developers. I hope the rest of the Shanghai market will not suffer. I am a little bit surprised that the market kept falling before 60th anniversary of founding of PRC on October 1.

Sep 29 11:27 PM

[fx_thoughts:]

"A CHOICE OF BILLION BUBBLES MUST NOT BURST"

The other main reason with perceptive rationale in investing into China's rotating wheels of fortune is the gradual appreciation of its RmB or Yuan; and already those elite QEII members and wealthy individuals from outside China have gained by money value of at least 20% over the last 24 months. That is quite pleasant to cover any sort of risks!

China is wealthy, dynamic and politically stable which carries with it a period into the future of prosperity and harmony. Hence, a political risk being a major risk factor in investment is being taken care of well. On top of its stability, it has a population of >60% x 1.35 billion heads still very poor relatively, even by China's own standard; and this opens up heaps of opportunities to invest in it and to grow with it. Hence, it does present a singular and secular shield of massive domestic market even if it cannot sell its finished goods abroad for and due to any stupid and/or unforeseen reason.

Caution remains that China has to invest its massive funds wisely and it can be seen that it has started to diversify its funds into foreign assets, forex, bad debts and equities internationally. One of which is in USA for the bucks and debt papers; and for this reason too it seems USD will eventually gain against all other majors like EUR, GBP, NZD and AUD, sooner or later, for they ride together with Japanese Yen: 3 superbly top class players! How is USD going to be sub_class relative to AUD, NZD, GBP & EUR over time?

China will wind down its foreign asset purchases as soon as it has developed its own comfort zone of mineral resources, gas and oil, and in particular AUD will suffer the most because the latter depends very heavily on China's purchases of Aussie natural resources and diary products; but not so much of China's growth effects. Whereas, Australia offers very little that China will buy from other than as mentioned above which will diminish over time; and besides, Aussie politicians will curb more sale of its resources when the time comes.

Keep a starry & weary eye on such developing scenario where AUD is being talked up; and one suspects that Aussie will not be the first to raise interest rate for whatever reason though 'they' have forgotten that Australia is a major exporting nation! Will a close_2_parity of AUD vs USD work for Aussie folks? Check for a realistic 'fair dinkum value' of AUD !

To the finishing line, this last Quarter offers plenty of exciting and nervious periods! Watch Yen, Yuan and USD for value!!

Sep 30 12:35 AM

[Paul Harper:]

A nice tell for this is the relocation of HSBC CEO to Hong Kong to get closer to the market, specifically with regards to a potential IPO on the mainland in 2010.

Sep 30 01:17 AM

[James Lewis:]

Lots of confusion.

People looking at western markets look for inflows from the Chinese Government trade surplus that is being collated in the chinese soveriegn fund.

People looking at Chinese market looking at inflows from foreign investors through the QF11 program.

Hong Kong investors looking at the illegal flows from the mainland into Hong Kong through the various underground channels.

Who's right?

I belive the Chinese market is fundamentally driven by the excess liquidity in the banking system that has built up due to the giganitc reserves built up and not sterlilised, the huge QE program the goverrnment has been involved in and not to mention the enourmous capital that has emanated from loan growth. It really has nothing to do with the QF11 programs. After all the western banks have very little disposable income on their balance sheets as they are just about reaching solvency.

If one is looking at Chinese market, one really needs to take a look at domestic policies, earnings, liquidity issues and valuations. Trying to work out what the western banks are going to do is useless. They are not calling the shots, this of course is what the chinese government wants.

In terms of premiums, the yuan is not freely convertible so there is no arbitrage analysis that can be done. The Hong Kong listed chinese stocks are priced in HKD, Shanghai listed in RMB, US listed in USD. There is inherent currency risk as the RMB could resume its strengthening even through a one time maxi revaluation.
Therefore to say Shanghai stocks are expensive compared to basket of stock in HK/USA is not true. A full analysis would have to be made of the corresponding currencies. Very hard to do as the RMB FX rate is only reliant on where the government decides it is to go. Anyone that has looked at the forward RMB-USD market will be able to appreciate how arcane future movements are.

I would say that I woudl happily pay 10-15% more for stocks in Shanghai quoted in RMB if my investment time horizion was more than 3 years and I thought now was a good time to buy. (Note I am not saying buy Chinese stocks here)

The best one can do right now is sit tight and watch what the chinese government has to say over the next couple of weeks. This will dictate price movements short (and maybe medium term).

Sep 30 01:28 PM

[ironmountain:]

Just curious if you actually trade currencies off those fundamental ideas?


On Sep 30 12:35 AM fx_thoughts wrote:

> "A CHOICE OF BILLION BUBBLES MUST NOT BURST"
>
> The other main reason with perceptive rationale in investing into
> China's rotating wheels of fortune is the gradual appreciation of
> its RmB or Yuan; and already those elite QEII members and wealthy
> individuals from outside China have gained by money value of at least
> 20% over the last 24 months. That is quite pleasant to cover any
> sort of risks!
>
> China is wealthy, dynamic and politically stable which carries with
> it a period into the future of prosperity and harmony. Hence, a political
> risk being a major risk factor in investment is being taken care
> of well. On top of its stability, it has a population of >60% x 1.35
> billion heads still very poor relatively, even by China's own standard;
> and this opens up heaps of opportunities to invest in it and to grow
> with it. Hence, it does present a singular and secular shield of
> massive domestic market even if it cannot sell its finished goods
> abroad for and due to any stupid and/or unforeseen reason.
>
> Caution remains that China has to invest its massive funds wisely
> and it can be seen that it has started to diversify its funds into
> foreign assets, forex, bad debts and equities internationally. One
> of which is in USA for the bucks and debt papers; and for this reason
> too it seems USD will eventually gain against all other majors like
> EUR, GBP, NZD and AUD, sooner or later, for they ride together with
> Japanese Yen: 3 superbly top class players! How is USD going to be
> sub_class relative to AUD, NZD, GBP & EUR over time?
>
> China will wind down its foreign asset purchases as soon as it has
> developed its own comfort zone of mineral resources, gas and oil,
> and in particular AUD will suffer the most because the latter depends
> very heavily on China's purchases of Aussie natural resources and
> diary products; but not so much of China's growth effects. Whereas,
> Australia offers very little that China will buy from other than
> as mentioned above which will diminish over time; and besides, Aussie
> politicians will curb more sale of its resources when the time comes.
>
>
> Keep a starry & weary eye on such developing scenario where AUD
> is being talked up; and one suspects that Aussie will not be the
> first to raise interest rate for whatever reason though 'they' have
> forgotten that Australia is a major exporting nation! Will a close_2_parity
> of AUD vs USD work for Aussie folks? Check for a realistic 'fair
> dinkum value' of AUD !
>
> To the finishing line, this last Quarter offers plenty of exciting
> and nervious periods! Watch Yen, Yuan and USD for value!!

Sep 30 03:16 PM

[snoopyjc:]

A powerful potential Gartley pattern on the Shanghai Index could lead to a tremendous buying opportunity in CAF at mid-Oct if it plays out:

chart.ly/fhqxy6

Also, the premium in CAF is only at 4% right now. If it goes higher when the underlying index returns to an uptrend, it could amplify your gains. Details here: www.cefconnect.com/Det...

--joe

Oct 01 07:42 AM