The Shanghai-Hong Kong Stock Exchange Connect was realized in 2014. 2 years down, Shenzhen Stock Exchange was also open to the international market through the Shenzhen Hong Kong Stock Exchange. The connections would allow investors outside of China to finally be able to invest directly in Chinese companies listed in China. Before this, shares listed in China, known as A-Shares, are only accessible to local investors.
I took the opportunity of the opening of this connection to start looking at some of the A-Shares listed in China. This is quite a tough process as the information of these companies are all presented in Chinese and it is still quite complicated to sort through the exchange website to search for information.
However, after searching for a few months, we come across one very interesting company. This company has been growing its revenue at 26.2% from 1998 to 2015. Its net income has grown at an even more impressive pace of 31.5% per year during the same period.
The company has a strong brand, given that it is the most popular liquor company in China. It achieved all these growths with a product that has a gross margin of 92%. This company is Kweichow Moutai Co Ltd (SHA:600519). The company seems like a good fit for my portfolio and I invested in it when it was trading at around 16 times its earnings.
Fast forward more than a year, A-shares are starting to gain more prominence as more investors get used to the idea of investing in them. Kweichow Moutai continues to show good growth in earnings and revenue. On top of that, its products are still in high demand, so much so that the grey market for its product, Kweichow Moutai Bajiu, was actually higher priced than its retail price. This means that collectors actually made money buying the product and reselling them.
Within the 12 months, the stock price of the Kweichow Moutai has shot up. In fact, it is one of the best performing blue-chip in the China stock market. The stock has rallied so much that the Chinese government has come out to comment that the stock should rise at a slower pace.
Kweichow Moutai has indeed been rallying very aggressively this year. For my investment, it was up more than 84% for the year. However, it is important for us to know that if our gains are contributed by a rise in fundamentals in the company or just a rise in expectation about the company. Here is what I mean.
Rise in Fundamentals
If the stock price of our investee company has risen by 100%, we can split out the gains to either gain from better fundamentals or gain from higher expectation. If the earnings of the company have also gained about 100% from last year, we know that the rise in stock price was mainly due to the better earnings power of the company. In effect, the valuation (price of earnings) of the company, has not really changed.
If the company is trading at 10 times P/E before and saw a 100% increase in both its earnings and its stock price, the company would still be trading at 10 times P/E.
Rise in Expectation
However, the stock price of a company can also rise due to the market getting more optimistic about the company. We can tell this roughly by seeing if its valuation (eg. price to earnings) move in relation to its stock price. If a company gain 100% at the stock price but its earnings are the same from last year, it means that its price to earnings ratio has actually doubled.
The company can see a sharp increase in price if its price to earnings ratio moved from just 10 times to 20 times even though the earnings might have stayed the same. When this happened, we can assume that the stock price rallied is mostly due to an increasing expectation of the company’s future.
As for Kweichow Moutai, it is a mixture of both, but I am assuming that the majority of gains is due to the huge jump of its price to earnings ratio from just 16 times when I first bought it to the current 35 times.
Reviewing Our Investment
It is a good exercise to check if our investment gains or losses are due to either improved fundamentals or expectation. And if we are completely honest with ourselves, if the returns are coming mainly from improving expectation of the company by the general market, that could just mean that we are lucky to have bought the company in advance.
Although I am having a great experience of buying my first China A-Shares and seeing it close to doubled within one year, I am in no illusion that the gains I am enjoying are the result of more luck than skill.