Investing In Public Chinese Issuers: A Look At The H-Share/B-Share Markets

by: Jiang Zhang

As China’s economy becomes an increasingly vital component of the world’s growth engine, investors have developed a strong attraction towards participating in its capital market. Even though the recent fraud allegations involving RTOs have caused great concerns among institutional and individual investors, China’s presence as an economic driver in the world economy is a fact that investors cannot simply ignore.

While many investors are fairly familiar with North American-listed ADRs and the abundance of China-focused ETFs that range from equity to currency, most investors are not aware that they are also eligible to trade Hong Kong-listed and mainland-listed Chinese companies through H-Shares and B-Shares.

Chinese equities include those that are listed in China’s Shanghai and Shenzhen Stock Exchanges, such as A-Shares and B-Shares, Hong Kong-listed H-Shares, and American Depository Receipts (ADRs). Because the mainland A-Shares are available only to the local Chinese investors and a group of qualified foreign institutional investors, many North American investors invest in ADRs, such as Baidu (NASDAQ:BIDU), China Mobile (NYSE:CHL), and Sina (NASDAQ:SINA). However, the Hong Kong-listed H-Shares and the mainland-listed B-Shares can also provide investors with an investment channel into China.

H-Shares are shares of companies that are incorporated in mainland China but are listed on the Hong Kong Stock Exchange. Currently there are over 1,400 companies listed in Hong Kong with a combined market capitalization of approximately $2 trillion, making it the fifth largest exchange in the world. For both institutional and retail investors, H-Shares offer several compelling investment highlights in terms of currency exchange, valuation, regulation, and financial products, aside from the obvious portfolio diversification.

Hong Kong’s H-Shares are traded in Hong Kong dollar, which is a freely exchanged currency pegged to the US dollar. For companies that list in both the mainland exchanges and Hong Kong, the H-Shares are usually trading at a discount compare to the mainland counterpart. But most importantly, companies that list on Hong Kong usually have stronger corporate governance due to stricter regulation and greater transparency. Finally, the well-developed equity derivative market gives investors more product offerings and allows them to have greater investment flexibility than they would in Shanghai, where the derivative market is still in its nascent stage.

There are also drawbacks with H-Shares, mainly due to the time zone difference and the indices’ overweight towards financial, energy, and telecommunication companies. For investors who want to emulate the index's return, buying shares of large Chinese banks and energy companies would suffice. This method is widely used by North American institutional investors in that many prefer Chinese banks, such as Industrial Commercial Bank of China (1398.HK), Agriculture Bank of China (1288.HK), and Bank of China (3988.HK). However, for those investors who prefer to invest in other sectors, conducting due diligence on Hong Kong-listed companies is not too difficult because many companies have both Chinese and English press releases and annual filings, which effectively minimizes the language barrier.

Local consumer-related companies such as Vitasoy (345.HK), and Tingyi (322.HK) offer investors an attractive opportunity to capitalize on China’s transition from export-driven economy to consumer-driven economy.

Vitasoy (345.HK) manufactures and sells food and beverages that include soy milk, tofu, tea, pasta, and other soy-related products. The company has a market cap of $700 million, trades at 18x forward earnings, and pays 3.4% dividend. Vitasoy has presence in China, Singapore, Australia and North America. Investors who are interested in conducting channel checks can easily find Vitasoy products, such as tofu and soymilk, in most of Chinese supermarket here in North America. The company recently recorded double digit revenue growth, driven by strong growth from Australia and China, and is keen on building its brand to consumers who are looking for a milk alternative and would like to incorporate soy-based products as part of their daily diet.

Tingyi (322.HK) sells “Master Kong” brand instant noodles, beverages, and snacks, and is the most well-known food company in China. It has a market cap of approximately $16 billion, trades at 30x forward, and pays a 1.5% dividend. The company recently reported 2011 results in which revenue grew 27% y/y and EPS grew 15% y/y. Tingyi is attractive due to its defensive nature as a company operating in the consumer staple sector. In my article on The Power of Brand Investing, I pointed out that a company’s brand is just as important as its other competitive advantages such as technology, patent, or distribution. According to a study done by global market research firm TNS this year, Tingyi was ranked 2nd “Most Valuable Brand in China”, after Sony (NYSE:SNE).

Aside from local Chinese firms, European companies such as high-end designer Prada S.p.A (1913.HK) and luggage-maker Samsonite (1910.HK) are also listed in Hong Kong and available for investors who like to invest in foreign companies that profit from China, in addition to Yum! Brands (NYSE:YUM), Nike (NYSE:NKE), or General Motors (NYSE:GM).

Before starting to trade Hong Kong-listed shares, investors must also be aware of the disadvantages, including the difference in time zone and poor liquidity for small caps (though liquidity would not be an issue for retail investors who buy in small blocks).

There are many brokers in North America who provide investors with a global trading platform. The most popular one is Interactive Broker, through which investors can trade on 90 markets in 19 countries. There are also others such as TD Waterhouse, E*Trade, and Scottrade.

The second option for investing in China is through the B-Share market, which is available to foreign institutions, foreign individuals, and local Chinese investors. There are only 105 companies listed on the B-Share Index (53 companies list in Shanghai while the rest are listed in Shenzhen). The Shanghai-listed B-Shares are traded in US dollars while the Shenzhen-listed B-Shares are traded in HK dollars. The B-Share market was originally created as a testing ground and a channel for local Chinese firms to raise capital from foreign institutions. However, with the emergence of QFII, which allows foreign institutions to trade the yuan-denominated A-Shares, the B-Share market slowly lost its appeal among foreign institutions. In addition, local Chinese investors are not attracted to B-Shares due to the small number of investable securities and the cumbersome process of converting the yuan into USD and HKD.

Contrary to what most investors believe, B-Shares do have value in that most of them are trading at half the multiple of their A-Share counterparts, yet receive the same amount of dividend. Furthermore, B-Shares are often overlooked by local Chinese investors who are notorious for their speculative investment style.

The reason behind B-Shares' steep discount can be explained by the information asymmetry, in which one party might have better information than the other. Foreign and local investors have different levels of information on the listed companies, in that local investors are usually better informed than foreign investors. In addition, the lack of understanding in language, culture, and regulations provides a daunting challenge to any retail investor investing in B-Shares.

As a North American investor, conducting due diligence on B-Shares is impossible without solid understanding of Chinese. While many Chinese brokerage firms offer B-Share account setups, only a few, such as First Capital Securities Ltd. (which recently formed an Investment Banking JV with JP Morgan), CITIC Securities, and Galaxy Securities, offer B-Share research. In addition, Chinese wealth management firms, including Beijing-based Cash Flow Consulting and Shanghai-based Noah Holdings (NOAH), could offer B-Share focused products to their clients as part of their financial planning process.

Manufacture sector accounts for 50% of the B-Share Index, and the rest of the Index is split among utilities, retail, construction, IT and mining. Within the Index, the largest two companies by market cap are Inner Mongolia Yitai Coal (900948) and Hainan Airlines (900945).

Yitai Coal (900948) specializes in mining and distribution of coal from Inner Mongolia, a resource-rich region of China that has an abundance of coal, cashmere, natural gas, and rare earth. The company has a market cap of $8.3 billion, trades at 9x earnings and pays a 4.1% dividend. China accounts for over 40% of global coal usage and approximately 80% of China’s power is generated from coal-fired power plants. Yitai’s competitive advantage lies in its dominance of mining operations in Inner Mongolia and it is focusing on developing a large coal-liquefaction plant that can supplement its coal revenue.

Hainan Airline (900945) is a regional airline based in China’s southernmost island Hainan. The company has a market cap of $4.1 billion, trades at 7x earnings, and pays a dividend of 1%. Hainan is one of the Special Economic Zones designated by Deng Xiaoping in the late 1980s as China started to transition into an open economy, and the island is more commonly known as “Chinese Hawaii”. The island is known for its beautiful beaches, clean air, and greenery, and attracted about 26 million visitors last year. Hainan is also the home of Mission Hills Haikou, the world’s largest golf complex, Miss World Pageant Contest, which is regularly held in the city of Sanya, Ironman Triathlon, and soon to be China’s 4th space launch center that is expected to open in 2014 and 2015.

Hainan Airline is the largest privately-owned airline in China and operates over 500 domestic and international routes. The company’s main base is Haikou Meilan International Airport, which is based in Hainan and 25% owned by the company, and has hubs in four other major airports including Beijing Capital International Airport and Xi’An Xianyang International Airport. Earlier this year, Hainan Airline became the first mainland carrier to be ranked as a 5-Star airline by Skytrax, UK-based consultancy that operates the world’s largest airline review site. Unfortunately, both China Eastern Airline (NYSE:CEA) and China Southern Airline (NYSE:ZNH), which are well-known by institutional investors here in North America, are ranked only 3-Star and 4-Star, respectively.

When I was in Beijing, my superior told me a story about a group of Israeli investors who went to the head office of Galaxy Securities in Beijing in 1992, when B-Shares were first issued, and opened the first retail B-Share account after reading about its creation in Israel. That decision turned out to be a wise one, for in less than a decade their investment more than quadrupled.

Even in the present, many investors are probably fearful when asked whether they would invest in the Iraq Stock Exchange. But little do they know that it is the best performing index in the world, up over 50% over the past year, and has experienced less volatility than we experienced here in North America over the past several weeks.

As Warren Buffett once said, “Be fearful when others are greedy, and be greedy when others are fearful.” Indeed, there could be a lot of fear and uncertainty involving investing overseas, but it is exactly this type of scenario that could present investors with extraordinary shareholder returns.

Investing in H-Shares, and especially B-Shares, is uncommon among investors in North America but both methods are accessible and could provide investors with attractive opportunities. While challenges in understanding the local language, culture, and regulation could prove to be daunting, but they are not difficult to overcome if investors are determined to conduct sufficient amount of due diligence. However, the most important aspect of investing in an oversea market, or investing in general, is to have a long term view and patience, or else trading commission would greatly reduce investors’ profit.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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