China's Highfliers May Be Headed For A Fall

Hong Kong-traded H-shares are so hot that skeptics see a bubble swelling

A year ago, Geng Xiaoping was baffled. China's economy, even cramped by SARS, was humming along while the profitability of its companies was picking up across the board. Ditto for his Zhejiang Expressway Co., an operator of toll roads. Revenue had risen 82%, and earnings had jumped 40% over the previous two years. Zhejiang Expressway's Hong Kong-traded shares, though, were bumping along at the bottom of the market, along with the rest of the 100 or so Chinese companies listed in the city.

Not anymore. Since last summer, Chinese enterprises traded in Hong Kong, commonly called H-shares, have staged a breathtaking rally, gaining over 150% from April to December. Zhejiang's stock is up 65%. "Investors from Europe and America are taking notice," says Geng, Zhejiang's chairman.

The market is so hot that a wave of China listings is expected to flood global markets in coming months. On offer: financial-services giant Ping An Insurance, phone operator China Netcom, Air China, and perhaps even China Construction Bank. All told, $15 billion in new China shares could be offered in 2004.

Is this a disaster in the making? Since Tsingtao Brewery became the first Chinese company to list overseas a decade ago, Chinese shares have rallied to record highs three times, only to crash with punishing results. Skeptics see a bubble swelling again. China stocks spiked over 50% in the fourth quarter alone. And on Jan. 12, when China Green, a small Fujian-based vegetable producer, sought to raise $24.8 million through a Hong Kong offering, orders were so strong it could have raised $4 billion. "The market is clearly very frothy," says Robin Parbrook, Hong Kong-based head of equities for Schroder Investment Management Ltd. A big shift in China's overall economy -- growing inflation, a slowdown in consumption, or a sharp rise in the number of SARS cases -- could send shares plummeting.

China bulls counter that this runup is for real. Underpinning the current market is China's booming economy, which grew at an official 9.1% clip last year. This is the first "true bull market" for China shares, says Kenneth Luh, head of China research at Credit Suisse First Boston (CSR ). Previous China euphoria, he says, was based on wishful thinking. "This time, it is based on robust earnings growth." Indeed, the average return on equity for Chinese companies grew to 11.9% in 2002, from 3.1% in 1998, according to HSBC Asset Management. And if some stocks were overpriced, optimists say, the market is already correcting itself. H-shares are down some 8% this year.

HIGH HOPES. Some say H-shares are cheap. Hong Kong-listed China stocks trade at price-earnings multiples of 15.3 on expected 2004 earnings, compared with 20 for the Standard & Poor's 500 and the 13.5 average for other emerging Asian markets. "As long as China's economy can continue to deliver growth and earnings remain strong, this market will support current valuations," says Philip Wan, head of investment banking for Core Pacific-Yamaichi.

Another change this time around: Investors are choosier, so Chinese companies no longer rise and fall in lockstep. Lackluster earnings have turned China's provincial conglomerates -- so-called red chips, which led the market in 1997 -- into laggards, while rising profits have pushed up the share prices of some private companies. The stock of Baoye Group, a profitable Zhejiang-based builder that raised $33 million in a Hong Kong initial public offering last June, has more than doubled since then based on investors' expectations of continued construction in the province.

Are such expectations overblown? There is no doubt China is stronger than in previous booms, and investors are more sophisticated. But that won't necessarily protect them if an ill wind blows this market down.

By Matthew Miller in Hong Kong

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