FXI: Possible Semi

Serjio74

A possible semi-catalyst to start closing the Shanghai premium over Hong Kong is about to emerge. Let me explain what this all means.

First, what's the Shanghai premium? Many probably don't know it, but a significant number of Chinese stocks have listings both in Shanghai (A-Shares) and in Hong Kong (H-Shares). These shares typically confer the exact same rights.

Yet, amazingly, and unexpectedly, the same shares listed in Shanghai and Hong Kong can trade at massively different prices. And nearly always, the difference runs in favor of the Shanghai-listed stocks. This happens to such an extent, that an index built based on shares simultaneously listed in both markets shows the Shanghai-listed stocks to be trading at an average 40% premium to their HK-listed equivalents:

The Shanghai Premium

Hong Kong Stock Exchange

This premium arose for multiple reasons, most prominently including:

Of course, for true investors which worry about the economics of the underlying business, the existence of this Shanghai premium is the same as saying there's an extreme HK discount. Hence, an investor which wants to lock down the economics of investing in Chinese equities will necessarily want to buy those securities in HK.

Anyway, this explains what the Shanghai premium is, and the most likely reasons for it existing.

Now, why do I talk about a "semi-catalyst" and not a full catalyst for wiping out the premium? This is also evident.

The only way to fully eliminate the Shanghai premium is to create an arbitrage mechanism between Shanghai and Hong Kong. That is, a mechanism where investors can buy/sell securities in Shanghai/Hong Kong, convert them to the equivalent securities in Hong Kong/Shanghai, and then sell/buy them there. Anything short of this won't fully eliminate the existing discrepancies. And this mechanism isn't yet what's on the table.

However, there is indeed something about to happen which might start some movement towards reducing these discrepancies.

The event, which is about to happen and might help reduce the discrepancies, is the impending launch (set to June 19) by the Hong Kong exchange of a "Dual Counter Model". What this model consists in, is the ability to trade Hong Kong stocks in both the HKD (Hong Kong Dollar) and RMB (Yuan), and to have an arbitrage mechanism between those two counters - ensuring consistent pricing between them.

This will have two effects:

Hence, this development will make the Hong Kong discounts more transparent and easier to take advantage of for mainland investors. This should in turn enable some narrowing of the extreme Shanghai premium / Hong Kong discount.

However, since this isn't yet a full-fledged arbitrage mechanism between Shanghai and Hong Kong, while we can expect some narrowing of the premium, we can't expect it to fully disappear. Hence, a "semi-catalyst".

Well, FXI is composed of Chinese HK-listed equities. These are, due to the described sentiment pressure, discounted equities. We can safely infer that if the equities which have Shanghai and HK listings are visibly, extremely discounted in Hong Kong, then those which don't have Shanghai listings will also be (just not so visibly).

Hence, FXI stands to benefit because:

Overall, it's not hard for Hong Kong to trade higher. The average equity held by FXI trades for just 10.9x Price/Earnings, and that's even though FXI's largest holdings list is mostly composed of high-growth companies which are already enjoying the first fruits of China's post-COVID economic reacceleration:

Some of the largest FXI Components

iShares

Of course, personally, I would favor individual equities which are most directly affected by this event, and where discounts are typically even larger than average. However, nearly all of those equities are only available by trading directly on the Hong Kong exchange and aren't covered by Seeking Alpha. FXI is possibly the next-best way of enjoying these investments.

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This article was written by

Portuguese independent trader and analyst. I have worked for both sell side (brokerage) and buy side (fund management) institutions. I've been investing professionally for around 30 years.

I have a Marketplace service here on Seeking Alpha called Idea Generator that's focused on deep value, real-time actionable ideas based on valuation and catalysts. The Idea Generator portfolio has beaten the S&P 500 by more than 74% since inception (2015).

I can be reached at paulo.santosATthinkfn.com.

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