Isaac Meng, CFA
BNP Paribas Peregrine Ltd

‘A’ market sell-off overdone

‘A’ shares plunged nearly 9% under profit-taking and market rumours of a
capital gains tax and possible rate hike. Capital gains tax is a low probability
but high impact event, which if approved would spark a major correction.
However, the long-term outlook is positive with PEG of about 1x for the
overall market amid the low rate environment.
The ‘A’ share market correction snowballed into a 9% plunge as market
rumours circulated of an imposition of capital gains tax and a possible rate
hike. This prompted massive profit taking and extremely heavy volume of
RMB197b, with a 6% turnover ratio, both unprecedented levels in China.
The ‘A’ share market has been exempt from capital gains tax for the last 10
years. China’s statutory capital gains tax is 20%, hence imposing the tax will
be a major negative which would certainly warrant a major correction.
In times of panic, investors have looked for excuses to sell. Capital gains tax
on stocks will signal a significant government policy shift from promoting
capital market development to pre-empting bubble risks. This rather unlikely
abrupt policy shift will be a direct contradiction of the government’s
fundamental policy of promoting domestic capital markets and indirect
financing.
We are not in a position to validate the authenticity of the rumours. However,
we believe that the imposition of a capital gains tax is rather difficult to
execute technically. It would involve the calculation of a tax basis to establish
profit/loss, and a regulation regarding tax loss deduction or carry over. Since
most corporates such as insurance/securities companies are already paying
corporate income tax, avoidance of double taxation makes a capital gains tax
system even more difficult to calibrate.
We consider the capital gains tax as a low probability, high impact event risk.
Even if the government decides to take steps to dampen the overheating
market, raising the stamp duty of 0.1% would be a move that is certainly far
more convenient to execute.
Overall, in the past few years, markets (both Hong Kong’s and the ‘A’ share
market) have tended to be weak approaching the NPC in early March. The
adjustment normally lasts till the end of March (see the table on the next
page). The seasonality might not be directly related to the NPC per se but
more due to the profit-taking after the Chinese New Year rally.
This correction is long overdue, especially for property and financial stocks.
However, as in previous sell-offs, the ‘A’ share market’s positive outlook
remains largely unchanged with an EPS CAGR of 25% in 2007-2008 and
average P/Es in the mid-20s after the sell-off. With PEG of 1x and real interest
rates negative, ‘A’ share valuations are not stretched.
The undiscriminating sell-off has brought many stocks closer to their fair value
range. We suggest investors take advantage of the volatile sell-off to
accumulate capital goods stocks, selected consumer stocks, utilities,
expressways, airlines, securities houses and selected banks.