Cheap China stocks lure arbitrage players

Arnout van Rijn cannot resist a good arbitrage opportunity.

He is now turning to mainland China, where equities traded there are valued at the biggest discounts since 2006 compared with their counterparts in Hong Kong.

Robeco is using its quota under the qualified foreign institutional investor programme to buy mainland consumer and industrial firms with dual listings in Hong Kong, anticipating the price gaps will narrow as an exchange link with Shanghai makes it easier for money to move between the two exchanges.

"I enjoy the discounts trade, because there is lot of free money as long as there is the staying power," said van Rijn, who helps Robeco manage about US$290 billion worldwide. "I don't care if it's going to happen now or in the next three years, if I just know that I'm on the right side of the equation."

The Shanghai Composite Index has dropped 2.33 per cent this year, compared with a 3.31 per cent fall in the H-share index.

The Shanghai and Hong Kong exchanges agreed on April 10 to allow as much as 23.5 billion yuan (HK$29.3 billion) of daily cross-border trading, opening up the mainland market further to foreigners while giving wealthy mainland investors a route to buy Hong Kong stocks. The authorities at the time said the link would start in about six months.

Existing rules restrict overseas money managers seeking investments on the mainland to foreign currency-denominated B shares, while only approved institutional investors can invest in yuan-denominated A shares.

There were US$56.5 billion of approved quotas under the QFII programme as of the end of last month, including US$235 million for Robeco, according to the State Administration of Foreign Exchange.

"A-share blue chips at discount to H are set to benefit," said Tony Lau, a senior equity specialist at Coutts & Co, which oversees about US$49 billion. "In the medium term, we believe fund flows from Hong Kong to Shanghai will dominate."

While the markets' valuation difference narrowed more than 4 per cent in the first month after the exchanges said they would link trading, the gap has since grown to the widest level since May 2006.

Mainland traders have turned more pessimistic on the outlook for stocks in the past three months, liquidating about 700,000 stock accounts since the end of March. That left the number of funded accounts at 53.15 million, a four-year low.

Some money managers were still waiting for further details on how the exchange link would work, including whether the mainland government would enforce a capital gains tax, said Ryosuke Kawahata, a Tokyo-based money manager at Mizuho Asset Management.

The mainland's personal income laws stipulate that gains from stock trading are subject to a 20 per cent tax, although the finance ministry and taxation bureau have exempted investors from the levy since 1994 to promote the development of the stock market. If concern over the tax regime still exists by the time the exchange link starts, the valuation gap mighty persist, said Alexandre Werno, a Shanghai-based executive vice-general manager of Fortune SG Fund Management, which oversees about US$11 billion.

MSCI cited unclear tax laws as one of the reasons it decided last month to exclude mainland shares from its global indices.

"We need to see the details," said Gerry Alfonso, a sales trader at Shenyin & Wanguo Securities in Shanghai. "The closer we get to having the programme running, and the more information we have, the more likely we are of finding opportunities."

For van Rijn, the potential for smaller discounts on A shares just adds to the appeal of a market that is trading at low valuations.

Among dual-listed consumer and industrial companies, Air China, the nation's largest carrier by market capitalisation, trades at an 11 per cent discount on the mainland.

"When you sit behind your desk and see all these gaps between these Shanghai-listed stocks and Hong Kong-listed stocks, you ask yourself: why aren't they closing more rapidly when everyone knows it's coming?" van Rijn said.