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Investors to get taste of new China via Shenzhen trading link

Foreign investors eager to tap into the next generation of Chinese firms should soon be able to directly trade stocks in Shenzhen, but the high valuations and extreme volatility of the country's second-largest exchange may limit early inflows.

[SHANGHAI] Foreign investors eager to tap into the next generation of Chinese firms should soon be able to directly trade stocks in Shenzhen, but the high valuations and extreme volatility of the country's second-largest exchange may limit early inflows.

The debut in November of the landmark Stock Connect trading platform between Hong Kong and Shanghai, although marred by technical problems, has been hailed by foreign funds as a fundamental step in the opening up of China's capital account.

Officials at the China Securities Regulatory Commission have said creating an investment channel into fast-growing Shenzhen, which hosts China's version of the US Nasdaq and ranks in the top 10 exchanges globally by market capitalisation, is the next move.

Industry insiders say an announcement is imminent of a start date for Shenzhen, which they expect in the first half of this year, although sources at the Shenzhen stock exchange say nothing has been formally approved. "Investors would love to see Shenzhen come online," said Nick Ronalds, head of equities at the Asia Securities and Investments Financial Markets Association. "Shenzhen is home to smaller, newer, more exciting companies." Undeterred by the slow start of Stock Connect, Beijing policymakers are rushing to get the new connection in place as quickly as possible to boost the chances of having Chinese shares included in the MSCI emerging market index, the main benchmark for emerging market stocks.

If China were to be included following the MSCI bi-annual index review due in June, billions of foreign dollars would flow into Chinese stocks from fund managers who model their portfolios on the benchmark.

Shenzhen, a metropolis of 14 millions within commuting distance of Hong Kong, is best known for being at the centre of Deng Xiaoping's 1980s experiment with capitalism.

Since then, the port city - a centre of the salt trade in imperial China - has positioned itself at the bleeding edge of financial market reform, culminating in 2009 with the launch of the ChiNext growth board for high-growth companies.

The index, which boasts industrial robotics champion Siasun , movie studio Huayi Brothers and a host of dynamic biotechnology, aviation and software companies, has outperformed the Shanghai Composite Index in 11 out of 18 quarters since 2010.

That could attract foreign funds wary of investing in the state-owned financial giants that dominate larger rival Shanghai, said Ding Yuan, an accounting professor at China Europe International Business School in Shanghai who also runs a hedge fund.

Shanghai stocks, which surged more than 40 per cent in the last quarter of 2014, tumbled nearly 8 per cent on Monday as financial shares took a beating after regulators tightened rules on trading with borrowed cash. The ChiNext fell 0.5 per cent, while the broader Shenzhen market dipped more than 3 per cent.

Despite its attractions, the Shenzhen stock market, home to some of the most speculative Chinese investors, is not for the faint-hearted.

For one thing, the smaller size of most of the companies makes them intrinsically more volatile on a price basis than big blue chips - one reason domestic speculators prefer them.

This volatility is aggravated by constant rumour-mongering and "leaks" intended to manipulate the market, despite repeated crackdowns by regulators.

Chinext's average intraday price volatility was almost twice that of the NASDAQ Composite Index in the fourth quarter.

There are also bigger challenges with corporate governance in Shenzhen, said Professor Ding, because, while Shanghai's stable of blue chip SOEs may be "boring", their largest stakeholder is the central government. "The probability of extreme wrongdoing (in state-owned firms) is lower as well, compared with Shenzhen," he said.

The Shenzhen exchange does still features many "old economy"heavyweights, including China's biggest real estate developer Vanke, Ping An Bank, telecommunications giant ZTE, and a slew of smaller manufacturing players in sectors such as textiles and chemicals.

Beijing could restrict foreign investment to those blue chips in the first phase - as it did in Shanghai - which would reduce the governance risk for foreign investors but also lock them out of the high-growth firms they are most interested in.

Finally, there is the simple question of how much foreigners will be willing to pay for these growth companies, some of which are dramatically overpriced compared with their peers.

The average price-to-earnings ratio for the Shanghai Composite Index stood at 14.55 at the end of last week, compared with an average PE of 21.35 for NASDAQ and 31.38 for Shenzhen's all-share index. ChiNext's PE was a staggering 59.85. "It's a very exciting opportunity, but investors will be torn," said Francis Cheung, head of China-HK strategy at asset manager CLSA in Hong Kong.