Why I've Finally Sold My China A Shares

Sep.25.07 | About: Morgan Stanley (CAF)

This has been an interesting exercise in some more active investing for me - essentially trading in and out of the Morgan Stanley China A Shares (NYSE:CAF) closed end fund a couple times this year, which is much more active than I tend to be with most of my holdings.

If you've been following my transactions, you might have noted that I bought shares in CAF back in May at about $36, sold at about $55, then re-bought shares at about $61.

And Monday morning, as the news that PetroChina would be getting a Shanghai A share listing lifted the enthusiasm for U.S. investors for all things China, I sold about two thirds of my position at $71.11.

Essentially, to re-cap a little, I like the medium term prospects of these shares. I see many more reasons for the domestic Chinese market to outperform over the near term than to underperform. But I'm not entirely confident that they'll avoid a bursting bubble, or that the path up will be an even one.

Like many other investors, I can't help but notice that the A shares look very expensive compared to most other investments, but then again, it also dramatically UNDERperformed most of the world for several years. There is so much money looking for a home in China that I think the bias of all investors should be for a rising market in everything domestic in China, including publicly traded companies.

I have tried to be disciplined, however - a significant part of my rationale for investing in this particular closed end fund has been the widely ranging discount to its net asset value, a discount that I think at least provides some downside protection at its extreme.

Buying the shares at a 20% or 25% discount to net asset value was a significant bargain, I think. But when the discount tightens to less than 10%, as it did Monday morning, I think the risk increases. Even though I can make an argument that this closed end fund should trade at a premium, not a discount (largely because it's a fixed portfolio size investment in an otherwise closed, and outperforming market), I can't make the rest of the market accept my argument in the short term.

Of course, the Net Asset Value is calculated after the close in China, so it doesn't include any news that might have moved the A share market since that close, like the PetroChina announcement.

But personally (and I'm going out on a limb here, I might be wrong), I don't see any reason why the A shares market in China should go up by 6% overnight tonight to close that discount gap -- I presume that for domestic investors in China the IPO of PetroChina will be an interesting opportunity to buy another big state-controlled company that was previously off limits, but I don't see any logical reason why it should lift the shares of any other unrelated company, or the holdings of CAF, immediately.

So I continue to hold some shares, but I'm taking profits with the majority of my CAF holdings here, at roughly a 16% return in one week. I am not a frequent trader, but trading around the discounts in an overall rising market seems to work pretty effectively for this holding, so I may revisit this again if the discount returns to appealing levels.

And as an aside related to this investment, I've also been thinking about my larger investment thesis regarding China, and about the conventional wisdom - particularly as it pertains to domestic Chinese investors.

Most investing pundits, myself included, have speculated that domestic Chinese investors will eagerly invest overseas instead of in their domestic markets once they are given the freedom to do so, partly because the A shares market is "overvalued," and partly because many Chinese companies don't trade in Shanghai or Shenzen, and they'll want to invest in them (this is part of my rationale for investing in Tencent in Hong Kong).

But consider the corollary of the U.S. stock market in the late-90s, all Americans had the freedom to invest overseas, and even to invest in ADRs of foreign companies quite easily, but the temptation to chase performance was much greater than the temptation to diversify internationally or to buy more "undervalued" companies. International investing for U.S. investors has grown massively in popularity in recent years, but that's because overseas is where the recent performance has been. In 2000, everyone in the U.S. wanted to invest in the Nasdaq, that's where the millions were being made. In 2007 and 2008, will the average Chinese investor want to invest outside China, presuming he's given that opportunity, and leave the hottest performing stock market in the world?

So, ignoring for a moment the argument about whether the A share market is indeed a bubble that will eventually burst, perhaps the real question is this: should we presume that most Chinese investors are more savvy and contrarian than U.S. investors were during the inflation of the tech bubble, and that they'll voluntarily sell their Chinese holdings to invest in other stock markets that are doing less well? I'm just wondering.