Mind the gap: Chinese, foreigners piling into Hong Kong H-shares, A-shares lag

Nichola Saminather

SINGAPORE, March 21 (Reuters) - Shares of Chinese companies

listed in Hong Kong are among the top performers in the world so

far this year, easily returning more than the S&P, as Chinese

investors pile into a market that was once the near-exclusive

playground of foreign fund managers.

Worried by signs that China is tightening monetary policy,

mainland investors are loading up on Hong Kong-listed Chinese

firms, which are trading at hefty discounts to the shares of the

same companies in Shanghai and Shenzhen.

Chinese are also pouring funds into Hong Kong as a hedge

against fears of further depreciation in the yuan currency

. Most Hong Kong listings are denominated in the local

dollar, which is pegged to the U.S. dollar.

The Hang Seng China Enterprises index, which tracks

H-shares, has surged almost 13 percent this year. The NASDAQ

is up just over 11 percent and the S&P 6 percent.

That rally has narrowed the premium commanded by

China's A-shares over H-shares to the lowest since December

2014, but investors say there is still money to be made.

Chinese investors remain wary of local shares after a crash

wiped trillions of dollars off its markets in mid-2015, said

Nicholas Yeo, head of China/Hong Kong equities at Aberdeen Asset

Management in Hong Kong.

"We've seen a reduction in participation by retail investors

in A-shares. They have been replaced by institutional investors,

who are looking to Hong Kong, where H-shares have been trading

at a discount for some time."

JUICY DISCOUNTS

Tight capital controls have limited the ability of Chinese

to get funds out of the country, prompting them to pour their

savings into A-shares and driving those prices and valuations

significantly higher than H-shares.

But in the last few years, programs connecting the Shanghai

and Shenzhen stock markets to Hong Kong's have gained traction,

giving Chinese a route to invest overseas, with the proviso they

repatriate the funds to prevent actual capital outflows.

The juicy discounts seen in Hong Kong have been too good to

pass up.

Using the stock market link-ups, Chinese investors pumped

$7.19 billion into Hong Kong stocks in January and February,

some 40 percent more than foreigners invested in mainland

shares.

The Shanghai Shenzhen CSI 300 index is up only 4.2

percent so far this year.

FOREIGNERS RETURNING TO GATEWAY TO CHINA

Adding to the boost for Hong Kong stocks, foreign funds,

which reduced exposure to Asia late last year as the U.S. dollar

strengthened, are now returning, drawn both by expectations of

global reflation and China's steadier economy.

That has whittled down the A-share premium over H-shares to

14 percent, compared with about 35 percent a year ago.

Chinese buyers have been largely focusing on H-shares of

China's banks for their relatively high dividend yields.

International investors, on the other hand, view Chinese

banks with scepticism, fearing their bad loans are much higher

than the lenders admit.

For instance, after a price gain of 15 percent in the last

three months, Industrial and Commercial Bank of China's H-shares

are now trading at 5.8 times forward earnings,

compared with 4.7 times a year ago.

For ICBC's A-shares, the closely watched metric

has seen only a slight change to 6.

"The shrinkage in the premium has been very narrow in focus.

Banks are the big movers behind that," said Tan Eng Teck, senior

portfolio manager at Nikko Asset Management in Singapore. "But

there's still a premium in other sectors."

Overall, the H-share index is trading at 8.3 times earnings,

up from 7.4 times at the start of the year.

Shanghai-listed A-shares are at 12.9 times, versus 13.2

times at the beginning of 2017, and Shenzhen-listed A-shares are

at 23.6 times compared with 24.5 earlier.

Given that H-shares remain cheaper than A-shares, investors

should still focus on the former, Tan said.

"Eventually, A-shares will come down to meet H-shares, so

you wouldn't want to buy A-shares," he said.

While H-shares still look more attractive, the recent surge

is leading international investors to contemplate the day when

the arbitrage opportunity closes altogether.

When that happens, some mainland shares will start to look

attractive, said Arthur Kwong, head of Asia Pacific equities at

BNP Paribas Investment Partners in Hong Kong.

"When it closes, we would be looking for unique stocks

listed only in China," Kwong said. "In Shenzhen, there are many

medium-sized companies not listed in Hong Kong, with very good

fundamentals. It will be more about stock hunting."

While most analysts believe Hong Kong's rally has room to

run, a reversal in bearish expectations for the yuan is a risk

factor, Tan warned.

If Chinese investors think the yuan has bottomed, "the

chances of them taking profits in Hong Kong and going back are

higher," he said.

($1 = 7.7651 Hong Kong dollars)

($1 = 6.9072 Chinese yuan renminbi)

(Reporting By Nichola Saminather; Additional reporting by

Saikat Chatterjee; Editing by Kim Coghill)