Stock connect 'will fundamentally change market'

'Through train' program is expected to inject new life into equities in Shanghai

Editor's note: The Shanghai-Hong Kong Stock Connect, popularly known as the "through train", is expected to launch next month and offer cross-border trading of mainland companies' dual-listed shares. The program, initially proposed in 2007, holds promise for the development of the nation's capital markets but also raises new issues of valuation and trading strategies.

The success of this arrangement can rationalize the diverging prices of dual-listed shares and help catapult the Shanghai Stock Exchange to the ranks of international exchanges. It will also provide immense profit opportunities for global institutional investors, whose increased presence is expected to re-shape the market.

Leveraging on its national network of reporters and expertise in business analysis, China Daily is running a series of articles that explain the significance of this groundbreaking program, identify the opportunities and risks and examine the issues that stock exchanges, regulators, financial institutions and investment advisers are sorting out.

Trading under the Shanghai-Hong Kong Stock Connect arrangement is widely expected to be dominated by institutions, which take a far longer-term view than retail investors, according to analysts in Hong Kong.

The program could lead to a fundamental re-rating of Shanghai's A-share market, which many analysts believe is oversold at an average price-earnings ratio of 10.73, compared with 11.45 for Hong Kong and 19.8 for New York.

Even such discounted prices have not enticed many retail investors, who just want short-term gains, analysts said. But they expect that a large inflow of investment through Hong Kong will change that.

"Foreign institutions we have talked to are interested in companies that have the potential to outperform their peers over a three-year horizon, rather than three months. That's so different from retail investors, who only care about how much profit they can pocket in three weeks," said Liu Hongke, chief economist and deputy head of research at China Construction Bank International Securities Ltd.

Lilian Leung, executive director of JP Morgan Asset Management, said: "We are expecting a market re-rating of A shares in the second half.

"The Shanghai-Hong Kong Stock Connect is a potential catalyst of the rally." she said. "Though it is just the start of the liberalization of the equity market, with much easier access to A shares, foreign institutions may finally change the investor structure of the market, which has until now been dominated by retail investors."

Leung, who has been involved in A-share research since 2005 and manages a fund worth 500 million yuan ($81.4 million) under the renminbi qualified foreign institutional investor program, said the market is rallying because the economy is stabilizing and because structural reform will fuel the country's long-term growth.

She also noted that the overall valuation of A shares has been "low" after a five-year contraction.

"Some of the big-cap good-quality companies are undervalued. They will be the first beneficiaries of the stock connect program," she said. "With increasing participation of foreign institutional investors and their buying power as a new force ... the whole market will be driven up as well."

Liu said that many State-owned large-caps are unpopular in the A-share market because retail investors shun them.

"But some of the companies are quite well-managed," he said. The leadership of China Mobile Ltd "is the most farsighted among the telecom firms I have visited".

Liu added that China State Construction Engineering Corp, Anhui Conch Cement Co Ltd and China Petroleum & Chemical Corp (Sinopec) "are all large-cap companies that are obviously undervalued".

She said that potential beneficiaries of SOE reform are in the spotlight because their operations and efficiency are set to improve.

Local SOEs such as power generation and equipment producer Shanghai Electric Group Co Ltd "will see faster moves", Liu said, adding that the progress of SOE reform has been "significant" this year.

Six enterprises at the central government level have been designated as test cases for reform and 15 cities and provinces have announced plans for local SOE reform.

"Some of them propose to split ownership equally among the government, shareholders and employees. It's a quite aggressive approach."

Leung said that retail, information technology and healthcare are the key sectors that will outperform the overall market in the long term. "We have overweighted them for quite long time," she said, adding that the fund will continue to underweigh traditional sectors such as material and energy.

Liu said that the A-share market offers much more choice in sectors such as healthcare and mass-market consumption.

For instance, home appliance makers Hisense Electronic Co and Haier Electronics Group Co are said to have great prospects. Shanghai Jahwa United Co Ltd, a maker of household and cosmetics chemicals, is worth noting as well.

The white liquor sector, led by Kweichou Moutai Co Ltd, as well as advanced equipment manufacturing and the defense industry are also likely to attract overseas buyers.

Financial stocks, on the other hand, are trickier. With issues such as local government financial vehicles and asset quality concerns weighing on Chinese banks, the central government is setting up regional asset management firms to fix the problem.

"The sector, particularly banks and brokers, is being re-rated at the moment. Their valuations have been very attractive. We have slightly overweighted these stocks to capture the potential uptrend," Leung said.

Though the influx of foreign institutions is expected to change the investor structure of the A-share market, 80 percent of daily trading volume is now generated by retail investors.

Liu said their dominance in the equity market will not change overnight.

She noted that institutional investors are very liquidity-sensitive. "They only buy stocks that are easy to sell."

For people eyeing quick money, now is the time to seize arbitrage opportunities between A and H shares, according to a report released by Shenyin Wanguo Securities Co Ltd.

Investors that currently have access to qualified foreign institutional investor and RQFII quotas, which are the official channels for foreign funds to access the Chinese mainland's equity market, can cash in by pair trading on companies dual-listed in Shanghai and Hong Kong, the report said.

If the share price of a particular company is more expensive in Hong Kong than on the mainland, for example, an investor can sell the Hong Kong shares and buy A shares at a discount. The reverse is true as well.

Trades of this kind will help minimize risks as price gaps between A and H shares should narrow after the stock connect program starts.

Tactically, Hong Kong's longer trading hours offer another opportunity. While A share trading in the mainland closes at 3 pm on most days, the market in Hong Kong goes for another hour.

"Taking advantage of signals in the final 10 minutes on the mainland, the Hong Kong market has more time to react to the trend, which A-share investors can then take refer to the next day," Liu said.