Buy, sell or hold?

With China's economy growing at more than 8% and most of the Fortune 500 racing through the door, China's domestic listed shares should be a welcome addition to any portfolio. But it?s not so simple.

China's two stock markets now have a combined market capitalization of US$500 billion – large, but still trailing Hong Kong's US$712 billion. Overall, the main indices are up around 16% since the beginning of this year, standing by mid-April significantly higher than they were at the same time last year.

Chinese domestic investors, while clearly eager for a return of a bull market, are wary. Government statements of support for the markets, such as one from the State Council in mid-February, do not support sustained rallies in the way they did in the 1990s. The base problems, while being gradually resolved, still weigh heavily on the market. That is, the generally low profitability of listed companies, poor standards of corporate governance, an ineffective regulatory structure and the fact that the companies listed on China markets, mostly large state enterprises, do not adequately reflect the wider economy.

Into this work-in-progress come foreign investors through the QFII channel, under which a dozen chosen international institutions, including UBS and Nomura, have been given quotas to buy Chinese domestic securities. There are some significant restrictions, not least of which that any shares bought by a QFII must be held for one year before they can be resold and that each investor can hold no more than 20% in any Mainland stocks.

So, if the China domestic share markets were really open to individual foreign investors right now on standard flexible terms, where would the smart money go? Given a continuing string of corporate scandals and the overall immaturity of the market, caution is the watchword.

"Chinese stocks by any measure are overvalued," said Hong Kong-based market watcher Fraser Howie, author of 'Privatizing China.' "The stock market is very unrepresentative of the Chinese economy."

Much of the attention remains on the big so-called Shanghai 50 – the largest and most powerful of the state enterprises that are effectively China's Blue Chips – Sinopec, Yangtze Power, China Mobile and the like.

"What investors have to ask themselves is, is this because there is nothing else to buy?" Howie said. "People are buying what other people are buying, it doesn't matter necessarily whether it's a good or bad company or not."

With price-to-earnings ratios Chris Ruffle, Shanghai-based director of fund house Martin Currie agreed, adding that with a long line of IPOs in the pipeline this year, investors will need to be careful about where they put their money. "The bull market in China is now fairly mature," he said. The China stock markets, created in the early 1990s, have been dominated from the beginning by high volume day-trading by individuals. "Chinese investors have played the market up, looking at shares as gambling chips," said Bruce Richardson, Shanghai-based head of research at Evolution Securities.

With price-to-earnings ratios in the high 30s, China's renminbi denominated A-shares are way out of kilter with, for example, the much lower priced H-shares traded in Hong Kong, he said.

The challenge is for China to reduce potential volatility by boosting the role of institutional holdings against the high turnover of trade by individuals.

One way authorities are hoping to do this is via QFII investment, the strict regulations of which are designed to tie up foreign institutional money for the long-term. "The great fear is that foreigners will come in, ramp up prices, and then pull out again," Richardson said, pointing to what he called unfounded worries of a high-speed Soros-type effect if regulations are eased. Another issue is that the average free float of A-share listed companies is 30%, meaning a whopping 70% of stock is non-tradable. What happens to these state-held shares looms as a potentially huge upset if and when Beijing decides to offload them.

What exactly is the plan is very much a work in progress, Richardson said – although he added it's unlikely Beijing would risk the bubble-popping effect of dumping them on the market outright. Then there is the immaturity of China's share markets to consider – lacking anything approaching the transparency or corporate governance of more established global markets. Last year, for example, a survey by regulators found that one in 10 of China's publicly traded companies had in some way or other fiddled the books.

A key factor, Richardson said, is that China's stock markets are still in the process of transformation into a realistic working mechanism for the allocation of capital. "The stock market was created to fund the technological renovation of SOEs," he said. "That failed – it put a lot of money in the hands of people who didn't know how to use it."

Given such words of caution and with a long way yet to go, analysts say those still looking to invest in China-related shares should think more broadly and instead consider Red Chips – Chinese companies registered in Hong Kong such as Shanghai Industrial and CITIC-Pacific, or even Taiwan-based companies operating on the mainland, such as food manufacturer Uni-President or consumer electronics group BenQ. The inching open of China's A-share market to a few Qualified Foreign Institutional Investors raises questions of the market's value A-share doubts still linger

Place your bets
Cary Zhang, Chief Marketing Officer with Fullgoal Fund Management in Shanghai says, unlike 2003, when you could make a good gain from picking a particular sector, in 2004 it is careful picking of individual stocks that matters.

"At the moment we are bullish on electric power and coal mining," he said, sticking with the energy, resources and commodities focus fueled by China's development drive. Stocks such as PetroChina, Huaneng Power International, Aluminum Corporation of China, Continental Minerals and petro-chem giant Sinopec remain hot names among investment analysts.

Also showing promise, says Zhang, is the IT sector. Two companies to watch are semiconductor producer Hangzhou Silan Microelectronics and TCL Corporation, an increasingly prominent consumer electronics brand in both the Chinese and global markets. Steel giant Baosteel, the fifth largest producer in the world, is another major stock that continues to get a lot of attention – part of the commodities boom on the back

China's rising demand for air passenger and cargo capacity is providing opportunities for the world's commercial aircraft manufacturers estimated at US$197 billion on around 2,400 new aircraft by 2020.

Airbus and Boeing both expect China's aviation market to grow slightly ahead of its economy – a rate approaching 10% – far higher than any other major world market. More than 80% of China's spending will go on boosting capacity, rather than replacing existing aircraft, making its aviation market second in importance and size to only the US.

Aware of China's potential, Airbus and Boeing have invested decades and millions of dollars in courting both its airlines and the officials who control the purse strings. Around 70% of China's fleet of about 686 aircraft are currently Boeings, but Airbus has scored some big deals recently – part of its goal to corner half the China market.

Both manufacturers refer to their China relations as a "strategic partnership" emphasizing investments in outsourcing component manufacturing, China-based service centers and the training of Chinese personnel.

"We are not just selling airplanes to China, we also invest in China, buy products from China and we have trained more than 24,000 aviation professionals," said Boeing spokesman Ross Ma. It is a similar story from Airbus – the result of China's push for investment in its domestic aviation industry and a drive to eventually produce its own aircraft.

Jim Eckes, aviation consultant with Indo-Swiss Aviation, said the process is akin to reinventing the wheel. Building aircraft is not like building TVs or fridges, he said, and China's history in the commercial aircraft business has so far not been so successful.