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SummaryDespite a massive surge in the Shanghai Stock Exchange Composite, Chinese equities are still attractive ona relative basis.

Hong Kong stocks are even cheaper as returns have lagged.

As Mainland Chinese investors gain increased access to Hong Kong stocks, look for the valuation gapbetween dual-listed shares to close.

Expected future returns for Chinese equities are far more robust than the expected future returns of U.S.equities.

Valuation conscious investors should strongly consider adding the iShares MSCI Hong Kong ETF to theirportfolios.

The Chinese stock market is up, I don't know, 140 percent in six months after being in adowntrend for five to seven years, and it's doing so on record volume with record breadth. If itwas any other stock market or certainly any developed market, I would tell you, being a marketobserver, there's a 98 percent chance China will be in a cyclical boom 6 to 12 months fromnow. Because it's China, and we don't know the nature of what we're dealing with here relativeto normal mature developed markets, I would downgrade that assessment from (98 percent),but I would still hold it over (any other likely outcome)... I would point out that the H shares inHong Kong representing China are 10.1 times earnings.

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William Koldus, CFA, CAIA, Koldus Contrarian Investments, Ltd. (318 clicks)Contrarian, deep value, long/short equity, portfolio strategyProfile| Send Message|(1,364 followers)

Chinese Stocks Are Cheap, Hong Kong Stocks AreEven CheaperMay 20, 2015 12:38 PM ET | About: iShares MSCI Hong Kong ETF (EWH), Includes: FXI, SPY by:William Koldus, CFA, CAIA

- Stan Druckenmiller

IntroductionIn one of my few good calls that I have made as a published author on Seeking Alpha (I started publishingin 2013, well after my glory years of making money in a down market in 2008, posting extraordinary returnsin 2009, and managing a top percentile long-short strategy for my firm from 2009-2011), I highlightedChinese stocks as a bargain in 2013. Since that juncture, Chinese shares have risen substantially. That raisesseveral questions. Are Chinese shares overvalued? Why do Hong Kong blue chip companies trade at adiscount to their Chinese counterparts? What are the expected future returns for Chinese investors? If giventhe choice, would an investor be better off buying the iShares MSCI Hong Kong ETF (NYSEARCA:EWH)and/or the iShares China Large-Cap ETF (NYSEARCA:FXI) or the SPDR S&P 500 ETF(NYSEARCA:SPY) today? We will answer those questions in this article. The answers are clear, definitive,and they may surprise you.

Off To The RacesAfter struggling substantially from late 2009 to the middle of 2013, the Shanghai Stock ExchangeComposite Index ($SSEC) exploded in the middle of 2014, doubling in price over its 2014 lows, as shownin the chart below:

After lagging the broader Shanghai Composite's rally during its initial phases, the iShares China Large-CapETF has participated over the last year, though still not to the degree of the Shanghai Composite, rising 45%in this time frame.

Over the past two years EWH has lagged both FXI and the Shanghai Composite Index, and is up a moremodest 23% over this time frame. One additional interesting feature of EWH is the fact that it has had lowcorrelation, and often-negative correlation to the S&P 500 Index over the prior two years. The performanceof EWH relative to the FXI and the Shanghai Composite Index, along with its correlation to the S&P 500Index is shown below:

With EWH lagging both the Shanghai Composite Index and FXI over the last two years, I believe it is wortha closer look to examine the opportunity.

CompositionThe iShares MSCI Hong Kong ETF is dominated by financial companies, which make up approximately62% of its holdings. Personally, I have been looking at some of the out-of-favor casino stocks, included inEWH, as individual holdings, which are in the consumer discretionary sector, for an intrinsic valueopportunity based on discounted cash flow analysis.

(click to enlarge)

Valuation - iShares MSCI Hong Kong ETF

EWH trades at 10 times earnings today.

PORTFOLIO CHARACTERISTICS:

P/E Ratio

As of 15-May-201510.71

P/B Ratio

As of 15-May-20151.42

Arbitrage OpportunityHong Kong blue-chips, who have their shares dual listed in mainland China, have seen their shares trade atroughly two-thirds the value of their Chinese counterparts over the past six months. Thus, there appears tobe an arbitrage opportunity, as the shares of the same company can be bought in Hong Kong much cheaperthan they can be purchased in China. The closing of this valuation gap is one of the most compelling reasonsto buy EWH. A catalyst for the closing of this valuation gap exists on the horizon in the form of theincreased fund-flows from Mainland Chinese investors to Hong Kong via a link-up between the Shenzhenand Hong Kong stock exchanges. This follows a Shanghai-Hong Kong link up that was introduced inNovember of 2014. As anticipation builds for the Shenzhen link-up, there have been strong share priceadvances in Hong Kong stocks, including a ten percent gain in the Hong Kong Growth Enterprise Market(NYSEARCA:GEM), which is a market of smaller capitalization growth stocks, during a single week inearly April of 2015. Investors have been maximizing their daily quotas for the link-up between the Shanghaiand Hong Kong stock exchanges, and this has resulted in record volume for Hong Kong stocks.

Despite the buying pressure from Mainland Chinese investors, Hong Kong blue chip companies remainsignificantly undervalued versus their Mainland listed counterparts. With an obvious arbitrage opportunity,investors might ask why this has continued to persist? The reason is that investors remain skeptical of thevaluation gap closing because the premium between Chinese shares and their Hong Kong cousins actuallyincreased after the Shanghai-Hong Kong link-up was launched in 2014. It appears, however, that there isnow sufficient liquidity to close this valuation gap as Chinese regulators are now allowing Chinese mutualfunds to invest in Hong Kong stocks.

Valuation - Chinese EquitiesWhile the Chinese markets and related share prices have appreciated dramatically, valuations in Chinashares and Chinese related investments are nowhere near the nosebleed valuations of U.S. stocks, asmeasured by the S&P 500 Index.

The following table, which I have obtained from StarCapital, and then edited, shows a broader perspectiveof global valuations, specifically where China stands on a relative basis. (Note: The valuations are from theend of February, since that time frame China shares, specifically the Shanghai Composite, have appreciatedsignificantly, however, the point remains salient with regard to relative valuation):

(click to enlarge)

In summary, relative to the United States, Chinese shares are clearly undervalued using any of the abovelisted valuation ratios.

Expected Future Returns - China Stands OutI took nearly a year and a half hiatus from writing for Seeking Alpha. During this time away frompublishing articles, I experienced the worst period of investment performance in my nearly twenty-yearprofessional career in the markets. These mistakes in the investment markets, hung a dark cloud over mypersonal and professional relationships. After many years of success, I re-discovered that managing moneyfor others is extremely difficult, particularly when you are wrong. Having experienced both the ecstasy ofbeing spectacularly right and delivering spectacular returns and/or saving capital in a down market, and theagony of being wrong and hurting people financially when everything is rising in price, I have anappreciation for the difficulty of investing for others that only comes with experience. Both feelings,accomplishment and failure are powerful, but having climbed up back from the depths, I can say with arenewed perspective that I do not wish the feeling of losing money for clients, many of whom were myfriends, on my worst enemy. It is truly a devastating feeling, and it will forever color my investment careergoing forward. The first article I authored after my sabbatical from writing was titled "Raise Cash, Prepareto Short U.S. Stocks, And Buy Out Of Favor Assets," as I struggled to understand valuations in the currentmarket environment. To illustrate the extremity of the current bubble and its scope, I put together a tablethat showed expected returns for various asset classes from GMO, and I have reproduced that table below:

(click to enlarge)

In short, asset class returns overall, according to GMO, which I believe is the best forecaster in the business,are as low as they have ever been for all asset classes. The forecasted returns are particularly dismal for U.S.stocks and bonds. However, in China, the expected returns from equities are much more favorable as shown

in the chart below, which I created with information from gurufocus.

(click to enlarge)

The calculation methodology employed by gurufocus relies heavily on the percentage of total marketcapitalization to GDP, which happens to be a favorite metric of Warren Buffett. Additionally, it considersdividends, and future business growth, which is the most questionable input in my opinion, as future growthrates are assumed to be the same as past growth. Even adjusting for that input, there is no doubt thatemerging markets, and particularly China, appear undervalued relative to their developed equity marketcounterparts, particularly the United States. One final note, the expected returns for the U.S. stockmarket, forecast by gurufocus's model, are projected at zero percent annually, which is actuallybetter than GMO's predictions of annual losses in U.S. equities over the next seven years.

Is A Cyclical Upturn Straight Ahead?No matter how you analyze it, the price rally in Chinese and Chinese related shares is impressive, and it issuggestive, as Mr. Druckenmiller has said, of a forthcoming cyclical upturn for China, even if Chinaremains in a longer-term structural downturn. What would that mean for downtrodden commodity relatedinvestments? That is a topic for another article, or a series of articles, that I am writing and have authored.With regard to Chinese shares, cynical analysts may ask, how could Chinese stocks be advancing with thenever-ending series of poor economic statistics? The simple answer is that stock markets are forwardlooking, and perhaps, the Chinese stock market is anticipating the future impact of interest rate cutsalongside other monetary easing measures that are being implemented. Everyone in the world has learnednot to fight the central backs, as short sellers have been eviscerated. If the U.S. and Europe can "goose" theirstock markets with easy liquidity, why can't China do the same?

Conclusion: Chinese Stocks Are Relative Bargains With HongKong Standing OutWith the stratospheric rise in Chinese equities, particularly the Shanghai Stock Exchange Composite Index,many investors are wondering if there is a bubble in Chinese stock prices? This recent article from theEconomist captures the sentiment of the Chinese bears. However, when investors analyze valuations andfuture expected returns, Chinese related stocks, particularly the Hong Kong shares, look remarkably cheap,especially if there is any forthcoming cyclical upturn in China. There are sufficient catalysts on the horizon,including a flood of Mainland Chinese money that is poised to close the valuation gap that exists betweenHong Kong and Chinese dual listed shares. This arbitrage opportunity will serve to unlock the valueinherent in the Hong Kong stock market. Thus, investors should consider diversifying their portfolios bybuying EWH, as it is a non-correlated, undervalued security, with an attractive risk/reward profile. To close,given the choice, at today's price and valuation levels, I would rather own the iShares MSCI Hong KongETF than the SPDR S&P 500 ETF. From a bigger picture perspective, most investors would benefit bysimply taking a small portion of their U.S. holdings and allocating them to emerging markets, with Chinastocks, and particularly EWH, being a fine destination for these rebalanced funds.

Disclosure: The author has no positions in any stocks mentioned, but may initiate a long position in EWHover the next 72 hours. (More...)The author wrote this article themselves, and it expresses their ownopinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author hasno business relationship with any company whose stock is mentioned in this article.

Additional disclosure: Every investor's situation is different. Positions can change at any time withoutwarning. Please do your own due diligence and consult with your financial advisor, if you have one, beforemaking any investment decisions.

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