One of the most popular new features within OTAS is the star ranking of directors, or insiders to use the US parlance, with regard to their share dealings. The directors who trade regularly and call the direction of the stock price correctly are awarded three stars and so on down through the ranking to those who don’t trade, or repeatedly get it wrong, who have no stars at all.
Back at the beginning of the year I published a blog entitled China Insider Selling Back at Peak Levels, in which I used OTAS to show that net selling by insiders at Chinese stocks was back at 2007 levels. There had been no positive EPS Momentum over the previous three months, which had led to a sharp re-rating of Chinese shares. However, when we compared this move to a longer history of valuation, it became clear that there was still significant headroom for Chinese shares to rally. And boy, have they rallied.
What is clear is that insiders at Chinese stocks had no more idea about what was about to happen than many other investors and commentators. Then as the rally developed, the number of voices that can be heard justifying the move and explaining why it will continue ad infinitum, has risen almost as quickly as the share prices themselves. Directors turned significant net buyers of shares earlier in the year, but in recent weeks have once again begun selling in size. Net disposals over the past month are $225m.
Recent history teaches us to be sceptical about this general trend, which is where the OTAS star ranking comes into its own. By going to the Director Dealings page for any watchlist, you may rank transactions by the most recent and see whether the sellers are three star traders that you ought to pay attention to, or no star no hopers whom you are best to ignore. You build a picture of insider activity from the bottom up, observing in detail the shares where the C Suite knows what it is doing and skipping over the names where it does not. I am not aware of another platform that allows such insight into insider activity across a market or portfolio.
Revisiting Valuation of Chinese Shares
After a few years on the OTAS project, I am getting the hang of when and where EPS Momentum is a good guide to share prices. In the long run little else is supposed to matter, as the value of stock is its discounted cash flows, but in the short term both sector and market have a great bearing on how closely share prices track EPS Momentum. Western consumer stocks fluctuate modestly around the trend in one year forward earnings estimates, and at the outer edges of a normal range present excellent buying and selling opportunities. Chinese shares, as is well understood, are more typically a play on real interest rates and a substitute for interest bearing investment in a country where real returns on bank deposits have for long periods been suppressed.
Throw in some deregulation, a few broker freebies for trading in Hong Kong and a general desire to diversify holdings of wealth internationally and you have the recipe for a proper bull market.
Back in January Chinese stocks traded at 16.8x 12 months forward earnings, which was the highest level since early 2011. However, as noted, it was also 40% below the upper bound of the normal range for these stocks, giving plenty of headroom for PE expansion regardless of trends in EPS.
Today, EPS Momentum is -0.4% and has been negative for the past three months, as was the case back in January. But these changes are small beer compared with the flow of funds pushing up stock prices and, on their own, will do little to dent the rally. Of greater interest is the forward PE, which now stands at 25.9x. The chart below shows that this has surpassed the top of the normal range, although remains some way shy of the two standard deviation point of departure and of the record valuation back in October 2007.
For those looking to spread some optimism about Chinese shares, this index of stocks has 13% further to run before its revaluation reaches the two standard deviation level and there is the possibility of overshooting once we reach that point. So, are there any more cautionary measures to observe?
In January, the first comparison made was with the Russell 1000, while noting that Chinese shares still had a long way to run if they were to return to previous relative rankings with US shares. Now in June, Chinese shares trade at an average premium of 45% to US counterparts, but this is within the normal trading range, which was last breached in 2009. Nothing to see here yet folks.
Chinese shares are a little more stretched against Japanese and Australian shares, although as noted before they had not plumbed the depths against the Nikkei 250 compared to other indices. Once again it is left to a comparison with the HSI to see how far and how fast Chinese shares have risen and at last, here is our cautionary note. Chinese shares are more than two standard deviations above their average relative valuation compared to Hong Kong shares and trade at a 72% PE premium. The last time this was the case was in October 2007, by which time the relative valuation was definitely on the slide.
One other observation that I made in January was that the dividend yield on Chinese shares was very much in the normal range for the stocks and that this was no reason for concern. Now, in June, not only is OTAS flagging a two year extremely low level of yield, the long term chart is almost at the two standard deviation low of 1% average yield, which was brushed up against in September 2007. In fact, just 7bps to go.
For those concerned with such long run measures as cash flow to shareholders and dividend yield, and there may be a few hidden amid the current frenzy, this is the warning sign that you have been waiting for. 65 of 262 stocks in my index yield at least two standard deviations less than normal and 141 yield below 1%. Check out OTAS for a list of names that includes mega caps such as Ping An Insurance, CSR and China Construction Bank.