Brokerage company CLSA (Credit Lyonnais) has put out a report saying that using A (domestic Chinese share) share prices to value China’s listed corporates does not reflect their true value. The report was written by Fraser Howie and is entitled “Does China’s stock market matter?” His key thesis is that A share prices have been distorted upwards since only a small percentage of the total ownership of flagship enterprises can actually be traded in the A share market.

Industrial and Commercial Bank of China (ICBC) is a good example to look at why Mr. Howie thinks valuations in the A share market are distorted because ICBC’s total market capitalization recently surpassed that of Citigroup. It is now the world’s largest bank by market value.

Typical of many of the leading companies in China, 73% of ICBC’s shares are owned by the Chinese government and do not trade. As a result, only 2% of shares trade on the A share market in China, while 24.9% of the shares trade as H shares in Hong Kong. Given the small domestic share float, the A shares trade at almost a large premium to the Hong Kong listed shares. Valuing the government’s holdings at the A share price would give ICBC a total market capitalization of US$281 billion. However, valuing those shares at the H share price would knock US$120 billion off ICBC’s market capitalization, according the report. A similar situation exists for many of the other large listed companies in China, including China Life and Sinopec.

At the Red Cat Journal, our concern goes even further. Is the H share price for shares of Chinese enterprises listed in Hong Kong also distorted by fractional free floats? To be sure, the distortion, if it exists, would be smaller than that for the A shares, but the question still remains. Whether this makes a difference to stock investors or not really depends on what the Chinese government’s plans are for its ownership stakes. That is unknown although we would bet on China retaining large ownership stakes in key companies for the near to medium term. Furthermore, we would also expect any sell-down in the government stakes to be orderly as market stability would likely be a key concern. However, if you are a strict fundamental investor, the limited float of companies may need to be taken into account when assessing intrinsic value.

For an article describing how Hong Kong share prices may also have been distorted upwards, see here.