China Growth Stocks

[tenenbaum]

WSJ article -- FXI trading at high premium to underlying

China Looks Good From Afar

By ALEX FRANGOS

There is something to be said for local knowledge. But what if the locals have it wrong?

That's a bet some foreign investors are making on China. With locals fleeing Shanghai stocks—the Shanghai composite is down 20% this year—foreign funds are clamoring to get their hands on highly restricted mainland shares, and paying a premium to do it.

Demand is evident in the price of exchange-traded funds that are listed outside the mainland but mirror the Shanghai market. On Monday, the iShares FTSE/Xinhua A50 China Index ETF was trading at 7.5% above the value of its underlying shares. The fund's average premium since the start of 2009 is 1%.

The premium is a byproduct of Beijing's restrictions on foreign investment. Regulators dole out investment quotas which are managed by investment banks. When demand for the ETFs is higher than the quota available, investors have to pay up. Last week investors poured $288 million into these funds, a Citi analysis of data from fund tracker EPFR shows. That's the most since December 2009.

So what do foreigners know that the locals don't? Outsiders tend to take a longer-term approach to China. Mainland investors are momentum players, holding stocks for two months on average, compared to six months in Hong Kong and a year in the U.S., says Morgan Stanley's Jerry Lou. The domestic crowd has recently been worried that government attempts to temper growth will overshoot the mark.

It's a common concern among investors at this stage of an economic recovery, and a correction is certainly warranted as investors wait to see the impact of tighter monetary policy. But foreigners see a market that's been sulking too long. Chinese stocks began their retreat last August, long before the global market rally came to an end. Outsiders are looking past the horizon of China's tightening program, betting that the economy will grow at a healthy clip even once monetary policy has returned to normal. Plus, valuations are compelling with Shanghai's shares trading at 14.6 times expected earnings, 17% below their eight-year average, according to Macquarie Research.

Certainly, the outsiders might be overlooking real risks. A slowing of the lending spree credited for China's recovery and massive fundraising plans by banks looking to shore up balance sheets could hang over stocks for some time.

But that's not stopping some fund managers from betting that when things turn around, the extra 7.5% they're paying for exposure to China will be small beans.

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