There are at least two nations within China -- the thriving east coast, and the vast hinterland, much of it still rural and populated by subsistence farmers. And nowhere is China's two-speed economy more in evidence than in its property prices. Investors can use that knowledge to make informed decisions on how to play Chinese property stocks, many of which are listed in the U.S. via ADRs.
U.S. investors are at an advantage since they can short the ADRs of the bad bets, whereas shorting in China is difficult, and only institutions can get access to the Shanghai and Shenzhen exchanges. Since some of the ADRs are thinly traded, exiting a position is potentially difficult, though. Stocks can also be shorted in Hong Kong as an alternate location for trading. So I will highlight some of the tickers to target either on the long or short side.
Fresh figures just came out showing the strongest performance in more than five years. The surge in house prices in China's Tier 1 cities is nothing short of remarkable. The cost of a new home in Shanghai rose 5.2% last month alone, and Beijing (3.8%), Guangzhou (2.4%) and Shenzhen (2.1%) also saw rapid price escalation in August.
I explained last week why this price surge is the most worrying element of China's strong recent growth figures, which clearly show that Beijing has steered the ship clear of a rocky economic beaching. Local politicians recognize the threat and are responding.
Hangzhou, the host of the recent G20 summit, where prices have risen 23% in a year, just set a record high by shifting 5,105 houses in a day this past Sunday. The rush came as buyers raced to avoid new restrictions that bar non-Hangzhou residents from buying a second property in the city.
Real estate is so popular in China as an investment that it effectively functions as a currency, Nicole Wong, the head of Hong Kong and China real estate at brokerage CLSA, says. Chinese people view property as an extremely safe and sensible asset to own, whether for their own use or for investment.
Actually, I agree. There's no other investment on earth that's so useful. No one lives in Apple (AAPL) stock, although I'm pretty sure there are a few people camped out in their stores. In China, property is one of the few asset classes available to investors, their only other options being the super-volatile stock market, cash or the murky pool of products in the "shadow banking" system. I'll explain why shadow banking, while extremely popular, is desperately unsuited as a way of backing the real-estate industry -- although that's one of the most popular targets for such lending. AAPL is a holding of Action Alerts PLUS.
As I mentioned yesterday, I'm at the CLSA Investors' Forum this week, hearing the thoughts of the bright minds at the brokerage -- as well as actor Drew Barrymore, who for some reason is one of the guests of honor. CLSA -- started 30 years ago by two former reporters -- focuses on Asian coverage, and now has the Chinese investment bank Citic Securities (CIIHY) as a parent. Even its U.S. operation, which launched in 2009, is intended to look at the 240 U.S. stocks that it covers through Asian eyes.
CLSA believes the China property market is overheated, and has an underweight recommendation on the sector. The Chinese property cycle typically runs about three years, with the trough-to-peak journey taking about six quarters. Prices are now rising faster than the last peak, in 2013, meaning this is the top of the cycle.
That being said, there are always winners and losers, even in a downcycle. Hang Lung Properties (HLPPY) , which has been opening a series of high-end shopping malls in China and is also a major Hong Kong landlord, is one of CLSA's 10 favorite China stocks, alongside the likes of Alibaba (BABA) and China Mobile (CHL) .
There are around 40 cities in China that are thriving, and property prices there are virtually bulletproof as a result. Then, in around 60% of Chinese cities, the population is stagnant or declining, meaning investors should avoid developers concentrated in such areas.
"The winning cities are very obvious: they've got talent, wages, access to capital," Wong says. Those cities indicate that "the property market in China is going to be the most attractive asset in China for a long time to come."
The brokerage says China Resources Land (CRBJY) and Longfor Properties (CRBJY) are the stocks to add to a portfolio, while investors should be avoiding Country Garden (CTRYY) , Guangzhou R&F (GZUHY) and Evergrande Real Estate (EGRNY) .
Aside from Alibaba, all of the above stocks are listed in Hong Kong, which can offer stronger liquidity than you might find with their U.S. listings. Hong Kong trading, 12 hours ahead of the U.S. East Coast, also has the advantage of trading in real time for China instead of taking overnight risk.
Country Garden and Evergrande are mass-housing producers with portfolios skewed towards smaller cities in China -- the ones that are most likely to be in trouble with big housing oversupply.
I've mentioned Evergrande before, since it is very highly leveraged and has a tycoon at its helm who veers in random directions. It was the company at the heart of a case that short seller Andrew Left lost in Hong Kong last month, after he issued a negative report on the company in 2012.
Left "disclosed false or misleading information" on the company, Hong Kong's security regulators at the Securities and Futures Commission ruled on August 26. He engaged in market misconduct with his sensationalist language stating Evergrande was insolvent and had committed account fraud, the SFC said. Left, who puts out negative reports on stocks he shorts at Citron Research, now says he is done with commenting on any trading in Hong Kong or China.
High leverage rarely stops Chinese property tycoons. "A lot of Chinese developers are cowboys," Wong says. "If you give them the ability to borrow, they will borrow."
If he were talking, Left would probably have plenty to say about the shadow banking system in China and how it is used to back real estate. This takes the form of loans masked out of the banking sector, typically taking the form of wealth-management products or entrusted loans made by companies or individuals to another company using a bank as the trustee.
Wealth-management products are not at all suited to the real-estate industry, since most only have a duration of around a year. But they are being used to back very long-term projects. In fact, 9% of those products invest in real estate, the third-largest destination behind only civil-engineering construction -- also part of the broad "let's build more stuff" sector -- and the management of public facilities.
Real estate and construction as an industry is also the third-biggest component of entrusted loans, taking 14.5% of that pot of cash. That's behind only investment in coal and mining, and public utilities.
Banks and trusts, which have used shadow banking as a way of masking risk, are now being pushed to recognize bad debts in those shadows. CLSA estimates the bad-debt ratio is 16.4%, or 4.2 trillion yuan ($630 billion) -- 6.2% of gross domestic product. Assuming collection companies and the lenders can recover 40% of that money, there's still a level of loss that stands at 2.5 trillion yuan ($370 billion), or 3.7% of the economy.
I'll discuss Hong Kong property stocks later this week, but CLSA is much more constructive on that sector than the China property tickers. Hong Kong developers are comparatively cheap and pay healthy dividends, whereas any dividends out of China -- already extremely rare -- would be eaten up for international investors by currency depreciation. The strengthening U.S. dollar and weakening yuan should lead to a 2.7% decline in the Chinese currency vs. the greenback through year end, with another 6.2% next year.
That would take the yuan from 6.7 to the dollar now to 7.3 come Christmas next year. Hardly the present that unhedged investors would like in their stocking.