Going de-CAF

Well, this has been an interesting exercise in some more active investing for me -- essentially trading in and out of the Morgan Stanley China A Shares closed end fund a couple times this year, which is much more active than I tend to be with most of my holdings.

If you've been following my transactions, you might have noted that I bought shares in CAF back in May at about $36, sold at about $55, then re-bought shares at about $61.

And this morning, as the news that PetroChina would be getting a Shanghai A share listing lifted the enthusiasm for US investors for all things China, I sold about two thirds of my position at $71.11.

Essentially, to recap a little, I like the medium term prospects of these shares -- I see many more reasons for the domestic Chinese market to outperform over the near term than to underperform. But I'm not entirely confident that they'll avoid a bursting bubble, or that the path up will be an even one.

Like many other investors, I can't help but notice that the A shares look very expensive compared to most other investments ... but then again, they dramatically UNDERperformed most of the world for several years, too, and there is so much money looking for a home in China that I think the bias of all investors should be for a rising market in everything domestic in China ... including publicly traded companies.

I have tried to be disciplined, however -- a significant part of my rationale for investing in this particular closed end fund has been the widely ranging discount to its net asset value, a discount that I think provides -- at its extreme, at least -- some downside protection.

Buying the shares at a 20% or 25% discount to net asset value was a significant bargain, I think. But when the discount tightens to less than 10%, as it did this morning, I think the risk increases. Even though I can make an argument that this closed end fund should trade at a premium, not a discount (largely because it's a fixed portfolio size investment in an otherwise closed and outperforming market), I can't make the rest of the market accept my argument in the short term.

Of course, the Net Asset Value is calculated after the close in China, so it doesn't include any news that might have moved the A share market since that close, like the PetroChina announcement.

But personally (and I'm going out on a limb here, I might be wrong), I don't see any reason why the A shares market in China should go up by 6% overnight tonight to close that discount gap -- I presume that for domestic investors in China the IPO of PetroChina will be an interesting opportunity to buy another big state-controlled company that was previously off limits, but I don't see any logical reason why it should lift the shares of any other unrelated company, or the holdings of CAF, immediately.

So I continue to hold some shares, but I'm taking profits with the majority of my CAF holdings here, at roughly a 16% return in one week. I am not a frequent trader, but trading around the discounts in an overall rising market seems to work pretty effectively for this holding, so I may revisit this again if the discount returns to appealing levels.

And as an aside related to this investment, I've also been thinking about my larger investment thesis regarding China, and about the conventional wisdom -- particularly as it pertains to domestic Chinese investors.

Most investing pundits, myself included, have speculated that domestic Chinese investors will eagerly invest overseas instead of in their domestic markets once they are given the freedom to do so, partly because the A shares market is "overvalued" and partly because many Chinese companies don't trade in Shanghai or Shenzen and they'll want to invest in them (this is part of my rationale for investing in Tencent in Hong Kong).

But consider the corollary of the late-90s US stock market -- all Americans had the freedom to invest overseas, and even to invest in ADRs of foreign companies quite easily, but the temptation to chase performance was much greater than the temptation to diversify internationally or to buy more "undervalued" companies. International investing for US investors has grown massively in popularity in recent years, but that's because overseas is where the recent performance has been. In 2000, everyone in the US wanted to invest in the Nasdaq, that's where the millions were being made. In 2007 and 2008, will the average Chinese investor want to invest outside China, presuming he's given that opportunity, and leave the hottest performing stock market in the world?

So, ignoring for a moment the argument about whether the A share market is indeed a bubble that will eventually burst, perhaps the real question is this: should we presume that most Chinese investors are more savvy and contrarian than US investors were during the inflation of the tech bubble, and that they'll voluntarily sell their Chinese holdings to invest in other stock markets that are doing less well? I'm just wondering.

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Another quick note on CAF

Well, one day -- actually a little bit less than 24 hours -- after I bought shares of the Morgan Stanley China A Shares closed end fund again, and the market tries to force some decisionmaking on me.

Why? Because the domestic Chinese stock market remains largely cut off from and uninfluenced by the rest of the world's markets.

Now, one argument is that this is certainly a reason to buy in if you can -- that's a kind of diversification that's hard to come across these days, thanks to the Chinese restrictions that limit foreign ownership of A shares, and limit ownership of foreign shares by Chinese citizens.

But another way to look at it is that the 20%+ discount to NAV that the fund was trading at yesterday morning has fallen significantly, down to close to 15% again as the US-traded CAF shares have enjoyed the market's rise and the return of optimism thanks to our latest rate cuts.

You see, the Shanghai and Shenzen exchanges were just about the only bourses that didn't see a pretty substantial rise yesterday/today (depending on where you are in the world). So in the last 24 hours the price of the CAF shares has risen about 8-10%, but the net asset value of the fund has actually declined slightly, since the Chinese markets were down a hair in their last trading session.

I just bought these shares, and I'm not quite ready to sell them yet -- I think that the domestic Chinese shares are likely to climb further, and I'm willing to give it at least a couple days. I will keep my stops tight to protect this surprisingly quick 10% return, but I think there's more to come.

If this same thing happens tomorrow, however, and the CAF shares narrow the discount further, I may be tempted to sell and book my profit. I think a 10% discount is probably reasonable for these shares, since that's close to where most closed end funds end up trading and this one carries a fairly substantial 2% management fee, but I'd argue that anything above that is a significant opportunity now, especially if you really want exposure to the Chinese economy that's not particularly swayed by US markets.

No guarantees on what I'll end up doing, however, since these shares also have traded at a substantial premium (albeit briefly, near their IPO last fall), and arguably ought to trade at a premium as the single best way for US investors to get direct exposure to the tightly controlled Shanghai and Shenzen domestic share stock markets.

Unless, of course, you believe that the A Share market is on the verge of popping like the good 'ol Nasdaq bubble ... I don't, though I think risk of some decline is high in general, but I can certainly see the validity of that point of view.

Just remember: Chinese income is climbing and their savings rate is at about 40%, and their bank deposits are losing money in real terms (due to inflation). Chinese citizens can buy property now, to some extent, though urban property can be incredibly expensive in some areas, but other than that they're pretty much stuck putting that savings into their stock market if they want decent returns (and some economists are now arguing that the reason for the high savings rate is that Chinese citizens want to invest in their economy).

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And ... back to the A Shares

Like a sloppy drunk returning to the roulette table, I've repurchased a position in the Morgan Stanley China A Share Closed End Fund (CAF).

Those who've been keeping up here (not so many of you, since I keep neglecting to post in a timely fashion), will remember that I bought these in the Spring because the discount was ridiculous, then sold when the discount shrunk to about 15% and the price was up well over 50%.

Well, I'm doing it again. I still see no fundamental reason for the decline in the A share market in the near future -- inflation is getting crazy in China, which should be good for stocks at least in comparison to bank deposits (and there isn't much else that the Chinese can do with their prodigious savings glut, even though they're beginning to loosen the restrictions a little bit and let some investors sample overseas fare).

And the discount is now back over 20% in this closed end fund.

So, I picked up some more shares today at an average of about $61.50.

This is, again, one of the few positions that I'm very cautious about -- I do have a trailing stop on these shares, which I almost never do with any other holdings, and I'm likely to sell if they continue to climb significantly and the NAV gets a little closer to the share price again.

But really, though I'm somewhat trepid about this position, I do think the A shares have quite a bit more potential in the short term of 6-12 months. Beyond being the most direct way of investing in the domestic Chinese economy, in my opinion, this is a play on supply and demand in two ways:

1) Chinese domestic investors have very few investments available to them, and they're mostly stocks on the domestic (Shenzen and Shanghai) A share market. So the A shares trade at a significant premium to the same company on the Hong Kong exchange, for example, in cases where companies have dual listings.

And 2) International investors have very little ability to invest directly in China. So this fund should trade at a premium to what foreign investors believe is the fair market value of the China A shares overall index.

The risk is that number 1 is moderated somewhat as the Chinese get the freedom to invest overseas -- but my bet is that this process will be extremely gradual, as most Chinese policy changes are, and that number 2 exposes the fact that most foreign investors believe the China A shares market is dramatically overvalued (due to number 1, mostly), so they may be paying a premium to what they believe the fair value is, but they believe, en masse, that the fair value is lower than the current net asset value.

So ... another gamble in a risky, isolated market. But frankly, in some ways I find the Chinese A share "bubble" companies to be somewhat more appealing than their US counterparts these days. If China can continue growing at 10% a year, as most believe they will come close to doing, especially as domestic consumption climbs in the Middle Kingdom, the valuations just aren't necessarily as crazy as they might look to jaundiced Western eyes that lived through the Nasdaq bubble.

We'll see, as usual ... I am leaving room to accept the fact that I'm wrong, and that an abrupt crash in the domestic markets in China is possible.

Full disclosure: I own CAF, and the China Fund CHN, as well as call options on the Hong Kong Index (EWH) and several individual positions in Chinese and asian stocks not directly mentioned here.

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Closing some Asian positions

Just a quick note that I'm closing my positions in a couple of Asian funds -- I've liquidated my holdings in the Morgan Stanley China A Shares Fund (CAF), and in the South Korean iShares Index (EWY).

CAF I bought because the pessimism over the domestic China market was overwrought, and the discount was too steep. Since then, the shares have gone up about 45%, and the discount has closed to about 11-12% depending on the price you use. I'm willing to sell here, since this was intended to be a short term trade to take advantage of what seemed to me to be too much pessimism. I agree with most people who believe that the A shares market is bound to correct significantly at some point, though I expect it will be later than anyone thinks right now (I can't see the shares really correcting until Chinese residents get permission to invest elsewhere). Still, I wanted a short term gain and got it, so I've sold.

EWY I bought a long time ago, because at the time Korea was nearly on par with the developed world in terms of the sophistication of its best companies and the stability of its economy, but it was being priced at fire sale levels. It was an easy way to buy into Samsung, Posco, a few Korean banks and shipbuilders, and Hyundai, all companies I thought would do well.

Well, with the exception perhaps of Samsung in very recent times that has come true -- and Korea is not a bargain anymore. It's probably still a decent investment, especially as a way to play one of the stronger economies that's likely to benefit from Chinese consumption (I like Korea for that more than Japan), but I'm no longer quite as enamored of the huge Korean megacaps as I was a couple years ago. They've been recognized, they're not cheap anymore, and since this index is essentially a play on the top ten Korean companies I'm going to take my 100%+ gain on this one and go home.

I continue to have pretty heavy exposure to Asia in my portfolio -- Naspers, Swire Pacific, The China Fund, the India iShares ETN, and Keppel Corp., along with options on NetEase, Gigamedia, Huaneng Power, Home Inns, CDC, and Satyam. But in these two cases, I have seen returns that exceeded my expectations and I think the risk/reward ratio has shifted out of my favor. Time will tell if I'm right, but sometimes it's comforting to hold a little cash in hand.

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A little Crazy ... a Little China

In what might be a dumb move, I've picked up shares in a couple of China closed-end funds in the last few days.

I've tried to hedge my bets a little bit, however: I have acquired shares of both the China Fund (CFN) and the Morgan Stanly China A Shares fund (CAF). These are extremely different investments, which I'll explain briefly. Basically, the China Fund is a mutual fund that buys stable, perhaps less-well-known companies that generally trade on non-mainland exchanges. I'd consider this to be the more stable fund, and a good long term investment. The China A Shares fund represents an investment in the actual bubble -- the Shanghain and Shenzen traded A shares market that is dominated by Chinese retail investors. Both trade at stiff discounts to their net asset value -- something on the order of 20% discounts in both cases, though that fluctuates a lot on any given day.

The China Fund is a more typical China mutual fund, with a long history, that happens to trade as a CEF. They have a couple of advisors, and they focus on buying non-state-controlled entities (this approach is common to many China stock advisors, including the newsletter editor Robert Hsu, who think the state owned enterprises are too bureaucratic and corrupt). I like this one because I appreciate the focus on smaller and unknown stocks that it would be difficult for me to buy personally -- they don't invest much on the A share market in Shanghai, but buy primarily Taiwanese and Hong Kong and other regionally traded shares that represent Chinese companies, or companies that primarily do business with China.

As of the end of April, their top holdings were:

Shanghai International Airport
Chaoda Modern Agriculture
China Merchants Bank
Daqin Railway
Shanghai Zhenhua Port Machinery
Golden Meditech
Financial Street
Xinjiang Tebian Electric
China Yangtze Power
Baoding Tianwei Baobian Electric
Powertech Technology
Cathay Financial
Merry Electronics
Formosa Petrochemical
China Oilfield Services

So I consider CHN to be a long term hold, which could obviously change. The expense ratio is a relatively reasonable 1.26%. CHN is now near a 20% discount to net asset value, which is nearly as high as the discount has ever been -- in contrast, the premium has occasionally gone as high as 60%, though I don't expect we'll see those numbers again. I don't think this fund deserves to trade at the same high discount as CAF, below, because of their relative lack of exposure to Chinese retail investors.

The China A Shares fund from Morgan Stanley (CAF) is more of a short-term bet for me. I think that it's entirely possible that the Shanghai markets will continue to climb for the rest of the next 12 months, on balance, even following the remarkable returns they've already had over the past year. There are definitely a lot more negatives with this fund, including massively higher expected volatility, but I think it's worth a gamble. With the shares trading at something like a 20% discount after being at almost as much of a premium as recently as December, and as the Chinese A share markets have continued to set new records despite all the talk of bubbles and state imposed control. This is essentially a small bet that at some point in the next few months -- before the Olympics next year, certainly -- US enthusiasm for the China A shares will return and that the markets will not have a crash. I could easily be wrong.

The top holdings of CAF, as of the end of March, were:
Huaxia Bank Co. Ltd
China Merchants Bank Co. Ltd
Shanghai Pudong Development BA
Daqin Railway Co. Ltd
Wuhan Iron & Steel Co. Ltd
Air China Ltd
Shenzhen Chiwan Wharf Holdings
Zhengzhou Yutong Bus Co.
China Coal Energy Co.
Maanshan Iron & Steel

As you can see, fairly limited overlap -- Dagin Railway and China Merchants Bank are in both funds, though I expect the CMB holdings in CHN are Hong Kong shares, not Shanghai (many companies list in both exchanges, at often different valuations). I've actually looked at China Merchants Bank as an independent investment idea before (in Hong Kong), because of their strong credit card business developing on the mainland, so I'm happy to have those shares doubled up in these positions.

The expense ratio is a relatively high 2%, thanks to the uniqueness of their portfolio in US markets, which is part of the reason I won't plan to hold this one for a very long time -- perhaps as much as a year or so, depending, of course, on how the market changes. I will likely keep a stop loss order on this one, which I almost never do for any investment.

So ... a couple Chinese investments. One long term because I like the investment strategy, one short term because I think the panic about A shares might be overdone ... and that short term one is on a much shorter leash, too. The CHN shares I purchased at $35.08, the CAF shares at $36.11.

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