When an extremely inflated stock market valuation combines with reckless financial leverage, what would be the final consequence? The freefall of China’s A-share market in the past three weeks provides an answer: a decline of more than 30% for the Shanghai Stock Exchange Composite Index†, with thousands of shares losing far more than that.
The burst of China’s A-share bubble, in essence, is no different from the collapse of the NASDAQ in early 2000, but is magnified due to the mindboggling leverage employed by investors in China.
For the past eight to 12 months, the most popular buzzwords from market participants in China are “internet +” and “O2O” (online to offline). Both are related to the use of mobile internet as a platform for businesses to reach potential customers and for consumers to look for goods and services before completing purchases.
Not surprisingly, few investors care about the true profitability or sustainability of these businesses. Valuation of shares linked to those buzzwords, regardless of their credibility, skyrocketed to reach 100 times P/E, or even higher.
Furthermore, margin accounts, stock index futures and stock index options – financial instruments available in most developed markets – were only introduced to Chinese retail investors in the past two years. One can imagine how convenient and attractive for speculators to deploy those new instruments when participating in this latest round of stock market mania.
The problem is retail investors in China have never had a chance to learn how devastating leveraging can be in an inflated capital market. Even if they were warned, most would tell you “this time is really different – it’s a new economy!”
In the meantime, inexperienced regulators have underestimated the severity of leverage in the market and how quickly it can cause great damage when the market turns.
When regulators finally realized the magnitude of risks of leverage in the A-share market in mid-June, brokerage firms were ordered to suspend lending on stock collateral and “gradually” reduce the total amount of those loans. This measure had the effect of pulling a few pieces of building blocks from the bottom of a market with a dazzling valuation, supported only by exuberance and outrageous leverage (from three to five times in many cases). The chain reaction began. Falling share prices triggered margin calls, shares were sold to meet those calls, share prices dropped further, and on and on.
Very soon, it gets to a point where the government has to intervene directly to prevent damage from spreading further. So far, measures implemented by regulators, including some quite drastic ones, haven’t stabilized the market.
Unwinding leverage in a capital market is a complex, painful and long-lasting process. It’s hard to see how the A-share market, in particular those overheated segments, can recover in the medium term, given how ridiculous their prior valuation level was. The costs and consequences of deleveraging will be felt by many parts of the economy in the coming months.
So what is the impact on Trimark funds that own Chinese companies? As I said in a previous blog after an extended research trip to China earlier this year, we didn’t participate in the craziness of the A-share market, and never intend to do so. We are invested in only one company listed in the A-share market. Its performance has demonstrated our quality-driven stockpicking discipline; with the index down roughly 30%†, the stock price of this company has barely moved in the past three weeks, and it’s gained nearly 40% † since we initiated the position in January of this year.
For other overseas-listed Chinese companies we own, we are seeing some short-term selling pressure incurred by panic and the liquidity squeeze by investors who were likely forced to sell those shares to meet cash requirement in China. However, provided the quality of those businesses and the moderate valuation of their shares, we are confident any pullback of share prices shall be short-lived.
If you have any comments or questions about our holdings in China, please feel free to leave them in the comments area below.
† Source: Morningstar Research Inc., as at July 7, 2015.