What the Shanghai-Hong Kong Stock Connect Means for You

By Michael Dow

Last year we saw one of the most anticipated equity market mergers of all time. On 17 November, Chinese authorities finally made a very long awaited move by agreeing to the connecting of the mainland's leading stock index to the Hong Kong exchange. The new two-way trading route also symbolises a broader trend of economic liberalisation and an increased internationalisation of the yuan. Above all else it means that many Chinese companies will now have access to more capital and foreign investors will have greater opportunities to get involved in the success story of the Chinese economy.

This all sounds great and it is certainly an encouraging indication of the Chinese government's willingness to liberalise the country's tightly regulation financial system, but what does it mean for both individual and institutional investors? In many respects this is actually a new world of opportunity for both mainland Chinese and foreign investors, as they will now have access to stocks that were previously unavailable within their respective jurisdictions.

One thing that has come to the forefront since the Stock Connect is the fact that the profound gap in valuations between the Hong Kong and Shanghai listings over the years has led to a number of large cap Chinese firms being grossly undervalued by mainland investors. According to Rutledge Capital, "the top 10 stocks listed in both markets, Hong Kong prices averaged 12.9% higher than Shanghai prices during the first 6 months of 2014 for shares in the same companies". This includes behemoth companies like PetroChina, ICBC, China Construction Bank, Sinopec Corp and insurance giant Ping An. Conversely however, a study showed that the top 69 companies traded on the Shanghai Stock Exchange as a whole have been trading at around a 10% discounted rate in Hong Kong for quite some time.

What this means is that investors can and most likely will capitalise on the disparities between large and medium cap firms' valuations on the respective stock indexes. If legendary money manager Jim Rogers is right though, investors shouldn't get too carried away with A class shares because "they are always the much more expensive". It is worth bearing in mind as well that many of the large or giant cap companies are SOEs (State Owned Enterprises), which means that question marks over future profitability and things like privatisation are always going to be influence investor confidence.

One of the great things about the Stock Connect is that it opens the door to interesting future listings on the stock exchange, of which there will no doubt be plenty in the coming months and years. Admittedly the small cap space in China presents considerable risks, but there are plenty of money making opportunities as well. As Louis Wong of Phillip Capital has pointed out, "investors should pay close attention to firms that are related to China's ongoing urbanisation and due to the environmental situation they need to consider companies that are involved in carbon emissions reduction, water treatment and renewable energy". And of course it is always worth keeping an eye open for upcoming Chinese firms that support the infrastructural development drive and provide services for the growing middle class are always.

The Stock Connect should also make China a better place to invest long term as it will give a big boost to the troubled Shanghai index and the wider Chinese economy as a whole. Over the last decade the Shanghai stock exchange has earned a reputation as one of the most volatile and disappointing equity markets in the world. After hitting an all-time high of 6,124 points in November 2007, the Composite Index then crashed in catastrophic fashion down to 1,614 and is now trading at around 2,850. Although it isn't as cheap as it once was, the index as a whole is definitely well priced relative to the intrinsic value of many Chinese equities that it is comprised of. Analysts are expecting to see some significant gains for the mainland stock market in the years ahead - partly as a result of the inflow of foreign capital following the Stock Connect, but also because China's GDP growth should remain above 6% per annum until at least 2020. Therefore, now could be a very good time to incorporate a broad spread of value stocks from the mainland into your long term portfolio.

But it isn't just about stock opportunities; it is also a very important development for those of us who are invested in the RMB long term. According to Nicole Yuen, Vice Chairman, Head of Equities and Chief Operating Manager of Credit Suisse in Greater China, "this move is the second step in a three stage process to fully internationalise its currency. The first step was to make it tradable, which they have been doing successfully so far, and the second is making it an investment currency". The next logical step for the Chinese authorities would be to allow the yuan to become an international reserve currency. At the moment it is still a long way from being fully internationalised but it is also probably undervalued as a result. So thanks to recent policy changes like the Stock Connect we may finally be able to realise the big gains that could come about from yuan-denominated assets.

Going forward, if the Shanghai-Hong Kong Stock Connect is a success then it would almost certainly pave the way for more such programmes. Right now those who are involved in the Shenzhen Stock Exchange in some way or another will have a very close eye on the situation in Shanghai. Since the Stock Connect came into effect there have been significant upsides and very positive sentiments from both mainland and foreign traders. A Shenzhen-Hong Kong Stock Connect would be very interesting indeed. Although it isn't as historically cheap as the Shanghai index, the Shenzhen Composite has remained fairly stable since plummeting after the global financial crisis. The Guangdong-based index is also full of hidden gems that would make for solid capital gains plays for savvy foreign investors if they were given the opportunity to acquire them.

There's no doubt that when it comes to investing our hard earned money, more options is always better. That's why we should be celebrating the Shanghai-Hong Kong Stock Connect and praying that the Chinese authorities continue to open the country up to outside investors.

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