A-share giveaways hand investors a poisoned chalice
There is no shortage these days of bullish pundits prepared to talk up the prospects of China's domestic stock markets. In the Year of the Dog, A shares will finally live up to their potential and generate decent returns for investors, they insist.
At first glance, the optimism seems well founded. Yesterday, the Shanghai A-share index closed at its highest since last March, up an impressive 24 per cent from its July low. And Shenzhen's A-share index has done even better, rallying almost 30 per cent over the same period.
Investors have waited a long time for the rebound. For four years, between mid-2001 and mid-2005, while China's economy boomed, Shanghai's A-share index slumped in value by 55 per cent. To add insult to injury, over the same period the main stock market index of India, China's fast-emerging economic rival, soared 200 per cent (see chart).
Investors blamed the vast overhang of non-tradable state shares. Fears Beijing was about to change the rules and sell off its stock, flooding the market with paper, sparked the start of a sell-off in 2001 and weighed on the market throughout its long slide.
Last year, with the Shanghai market sinking towards the psychologically significant 1,000-point level, the authorities were finally prompted to act. In April they introduced a programme to convert the overhang of state shares into ordinary tradable stock, while compensating minority shareholders for anticipated losses.
Since then, about 400 of the 1,300-odd companies listed on the A-share markets have rolled out compensation plans, which typically involve doling out free stock and promising not to sell off any shares for a two-year period.
The initiative has revitalised sentiment towards the domestic stock markets as investors have rushed back in, enticed by the prospect of free share handouts. With plenty more firms still to announce their plans, some analysts are forecasting gains of 20 per cent or more this year.
Yet, on closer examination, it is unclear that A-share buyers are getting a good deal. In a rational market, the recipients of free shares would gain nothing. Doling out stock would simply dilute the value of existing shares, pushing prices down, not up.
There is some evidence this is happening.
Take the example of leading high-end steelmaker Baoshan Iron & Steel, which announced its compensation plan in late June. At the time, this column predicted that the dilutive effect of the stock handout would drive the stock down 18 per cent in the following months. Yesterday, it closed at 4.08 yuan, down 20 per cent.
In contrast, the stock of rival Maanshan Iron & Steel, which did not publish its own compensation plan until last week, rose over the same period.
Other, similar examples indicate that the current rally is being driven by speculators buying to collect free shares and then selling out, rather than by an influx of long-term investors.
Meanwhile, many of the A-share market's original problems remain unaddressed.
Although prices are down massively from their 2001 peak, A shares still look expensive compared with Hong Kong-listed stocks. The Shanghai A-share index is trading at an estimated price-to-earnings ratio of 30.85 times, compared with just 12.52 for the Hang Seng H-share index.
For many mainland-listed manufacturing and property stocks, the earnings outlook is deteriorating as overinvestment in capacity has pushed costs up and product prices down. Corporate governance standards remain woeful, and with new share issues forbidden for the time being, executives have little incentive to raise their game.
There are some positive signs, including the gradual emergence of a long-term institutional investor base and greater openness to foreign strategic buyers. But these are long-term influences whose effects will take years, rather than months, to filter through to the market.
In the meantime, the current rally might turn out to be just another dead-cat bounce and today's optimism sadly misplaced.