The valuation gap between A shares and H shares is expected to dwindle, though the two share classes still won’t be fungible, notes a Credit Suisse analyst.

Victor Lin of Credit Suisse in a trading strategy report dated April 11, 2014 notes investors anticipating narrowing spread between A and H shares could profit by getting long exposure to A shares and shorting H shares.

Rough trading in Chinese A shares

Recently, Chinese shares crumbled after the government announced harsher-than-expected measures to curb the surge in property prices. Consequently, Chinese A shares, which track stocks listed on the Shanghai or Shenzhen exchanges, saw some rough trading last month. Though only Qualified Foreign Institutional Investors and Renminbi Qualified Foreign Institutional Investors have access to these shares, global investors can access these markets via the ETF route.

Earlier this month, the China Securities Regulatory Commission (CSRC) and the Securities and Futures Commission (SFC) have approved, in principle, a pilot program that would facilitate mutual market access between Mainland China and Hong Kong. However, the trading will be subject to a maximum cross-boundary investment quota along with a daily quota that will be monitored in real time

Valuation gap to narrow

The Credit Suisse analyst notes historically A-shares have usually traded at a large premium to H-shares, which can be evidenced from the following graph:

AH Premium Index Valuation Gap

However, the analyst points out that A-shares have traded at over a 5% discount to H-shares. The following graph highlights this aspect:

Tightening AH premium Valuation Gap

 

The analyst points out that such a magnitude of a discount has only occurred six times since 2006, as evidenced in the following graph:

A shares at a discount to H shares Valuation Gap

Possible profit through contrarian calls

The Credit Suisse analyst believes the recent news from CSRC and SFC could act as catalyst to bring the share classes back in line. Such a view is corroborated by the spread tightening by 1.7% after the announcement.

The analyst suggest investors anticipating the spread between A and H shares to revert to 0 could profit by getting long exposure to A-shares and shorting H-shares. The Credit Suisse analyst points out that the relatively recent innovation of U.S. ETFs physically backed by A-shares can make such a trade a little easier to implement now for those investors trading in the U.S.