A Preliminary Discussion on AH Premium

Review of Views: How Will the Market Move After the Valuation Rally? In last week's report, we mentioned that the rise in the Hong Kong stock market this year has mainly been contributed by the increase in valuations. After the earnings forecast for Q1 2024 bottomed out, it was validated by actual earnings data, making the Hong Kong stock market's performance aggressive starting in the second half of 2024. However, it should also be noted that the valuation increase since the beginning of the year has already fully accounted for further earnings recovery expectations for the year. In the past week, we have seen a decline in sentiment towards Chinese assets, especially in the Hong Kong stock market. During the annual report window, if there is no better-than-expected earnings performance, we still need to be wary of the risk of cooling off the valuation rally.

Preliminary Discussion on AH Premium: What Are the Determinants of Overall and Structural Premiums?

1. Currently, there are only 151 companies listed in both markets, including 145 H-shares and 6 red-chip companies. As of the end of 2024, the market capitalization of the listed companies in both markets accounts for 50.8% of all Hong Kong stocks, significantly impacting the weight of the Hong Kong stock index.

2. The relative elasticity of A-shares and Hong Kong stocks has changed somewhat around 2021. From 2012 to 2020, the AH premium rate was positively correlated with the CSI 300; since 2021, the AH premium rate has been negatively correlated with the CSI 300, meaning the convergence of the AH premium mainly occurs during the upward phase.

3. After 2021, the relative volatility of the Hong Kong stock market has increased, one speculation may relate to the reversal of relative liquidity discounts. After 2021, the core asset bubble burst, and the decline in A-share trading volume was more significant, with the turnover ratio of the CSI 300 to the Hang Seng Index decreasing.

4. In this round of upward market movement, the performance of Hong Kong stocks is significantly better than that of A-shares, mainly because the driving force of the market is more inclined towards the core technology assets in Hong Kong stocks, although these assets are generally not listed in both markets simultaneously. The listed companies in both markets still mainly consist of financial and stable assets, with the combined market capitalization of the banking, non-bank financial, oil and petrochemical, and telecommunications service sectors accounting for 67.7%.

5. The level of dividend yield plays a crucial role in the premium structure. Companies with higher dividend yields tend to have a smaller price difference between the two markets. The implicit logic here may be that consistently stable high dividends have more buying and holding value, thereby partially offsetting the liquidity discount.

6. The proportion of institutional holdings can somewhat verify this issue. Data shows that companies with higher holdings by international intermediaries tend to have lower AH premiums.

7. What conditions are needed to further converge the AH premium in the future: The most direct factor remains the elimination of liquidity discounts. In addition to southbound "inflow," institutional cooperation is also needed, such as reducing trading commissions, stamp duty, and the implementation of dividend tax reforms. From a longer-term perspective, it involves improving the overall quality of Chinese assets, enhancing dividend levels, and stability.

Risk Warning: Technological progress in the industrial sector may fall short of expectations; deterioration of the overseas economic situation and negative impacts from adjustments in the U.S. stock market; changes in the international political environment (China-U.S. friction, geopolitical issues, etc.) may bring additional shocks; Domestic economic growth and stabilization policies are below expectations (exports exceeded expectations but were dragged down by overseas demand, and consumer confidence in real estate is difficult to restore, etc.).

Report Body

I. Review of Views: After the Valuation Rally, How Will the Market Move

In last week's weekly report, we mentioned that the rise in the Hong Kong stock market this year has mainly been contributed by valuation increases (Table 1). Taking the Hang Seng Index as an example, as of March 14, the index has risen 19.4% year-to-date, while the price-to-earnings ratio (TTM) has increased by 20.1% during the same period. However, at the same time, the rolling earnings performance over the past 12 months has seen a slight decline—according to Bloomberg data, the actual EPS of the Hang Seng Index has decreased by 0.56% so far, and the actual ROE has declined by 0.14% year-to-date.

Does the flattening or weakening of earnings indicators necessarily mean a market downturn? Especially for the short-term market, valuation seems to have a higher explanatory power. The reason may be that if there are no disruptive changes, the fluctuations in earnings in the short term are relatively muted, or in other words, changes in actual earnings require a certain feedback time; however, fluctuations in valuation can be very dramatic.

The fluctuations in valuation imply trading on future economic trends. If we replace actual EPS with forecast EPS, its explanatory power for the market will significantly increase. Year-to-date, as of March 14, the market has raised its earnings forecast for the next 12 months by 4.13%, which is an increase of about 10.82% compared to last year's low, and this is the main support for the Hong Kong stock market to emerge from the bear market logic.

Generally, the trend of forecast EPS leads actual EPS, but there are cases of forecasting errors (Figure 1). When earnings forecasts bottom out, it often drives valuation recovery and market performance improvement. There are two possible scenarios:

1. In the first scenario, if earnings recovery is confirmed, as in Q1 2016, then after the valuation rally—valuation fluctuates at a high level, and actual earnings drive the main upward wave of the market, with a larger upward amplitude, longer duration, and smaller pullbacks.

2. In the second scenario, if earnings recovery is falsified, as in Q4 2020 and Q4 2022, then after the valuation increase— the market peaks and adjusts, significantly killing valuations.

After the earnings forecast for Q1 2024 bottomed out, it was validated by actual earnings data, making the Hong Kong stock market's performance begin to show aggressiveness starting in the second half of 2024. However, it should also be noted that the valuation increase since the beginning of the year has already adequately accounted for further earnings recovery expectations for the year. In the past week, we have seen a decline in sentiment for Chinese assets, especially in the Hong Kong stock market. During the annual report window, if there is no better-than-expected earnings performance, we still need to be wary of the risk of cooling off the valuation increase.


II. Preliminary Discussion on AH Premium: What are the Determinants of Overall and Structural Premium?

In discussions about the valuation of Hong Kong stocks, the rapid convergence of AH premium in the past period has also received widespread attention. As of March 21, the AH premium rate has converged to 130.55%, falling below the premium rate levels corresponding to the previous peaks—132.33% on April 26, 2021, 133.62% on January 20, 2023, and 133.31% on May 17, 2024. We provide the following information 整理：

1. Currently, there are only 151 companies listed in both markets, including 145 H shares and 6 red-chip companies (Table 2). As of the end of 2024, the number of listed targets in both markets accounts for only 5.7% of all Hong Kong stocks, but their market capitalization accounts for as much as 50.8%, thus this group of companies has a significant impact on the weight of the Hong Kong stock index.

2. The relative elasticity of A shares and Hong Kong stocks has changed somewhat around 2021 (Figure 2). From 2012 to 2020, the AH premium rate was positively correlated with the CSI 300 (correlation coefficient +0.68), meaning they moved in the same direction, with A shares generally exhibiting greater elasticity; the convergence of AH premium mainly occurred during downturns in the Chinese market. Since 2021, the AH premium rate has been negatively correlated with the CSI 300 (correlation coefficient -0.53), meaning they moved in the same direction, with Hong Kong stocks generally exhibiting greater elasticity; the convergence of AH premium mainly occurred during uptrends in the Chinese market.

3. After 2021, the volatility of the Hong Kong stock market relative to A shares has increased, one speculation may relate to the reversal of relative liquidity discount (Figure 3). After 2021, the core asset bubble burst, and the decline in A share trading volume was more pronounced, leading to a decrease in the turnover ratio of the CSI 300 relative to the Hang Seng Index.

4. In this round of upward market trends, Hong Kong stocks have significantly outperformed A shares, primarily because the market drivers are more inclined towards core technology assets in Hong Kong, although these assets are mostly not listed in both markets. Among the 30 Hang Seng Tech constituents, only Midea, Haier Smart Home, Semiconductor Manufacturing International Corporation, and Hua Hong Semiconductor are listed in both markets. As of March 21, the AH listed targets are still mainly composed of financial and stable assets, with the combined market capitalization of the four sectors—banking (34.7%), non-bank financials (14.7%), oil and petrochemicals (10.2%), and telecommunications services (8.0%)—accounting for 67.7% (Figure 4) 5. The level of dividend yield plays a crucial role in the premium structure. Figure 5 shows the relationship between the dividend yield level of A-shares and the AH premium rate, while Figure 6 shows the relationship between the AH dividend yield ratio and the AH premium rate. The results indicate that companies with higher dividend yield levels have a smaller price difference between the two markets. The implied logic here (especially for institutional investors) is that a consistently stable high dividend is more valuable for buying and holding, thereby partially offsetting the liquidity discount.

6. The proportion of institutional holdings can somewhat validate this issue (Figure 7). Due to data limitations, we cannot accurately determine the proportion of holdings by various types of institutions, so we approximate this with the proportion of holdings by international intermediaries (which actually also includes individual investors). The data results show that companies with a higher proportion of international intermediary holdings have relatively lower AH premiums.

7. What conditions are needed to further narrow the AH premium in the future: We believe the most direct factor still lies in the elimination of the liquidity discount. In addition to the southbound "inflow," corresponding institutional cooperation is also needed, such as reducing trading commissions, stamp duty, and the implementation of dividend tax reforms. From a longer-term perspective, it involves improving the overall quality of Chinese assets, as well as enhancing the level and stability of dividends.


This article is authored by Liu Chenming, Xu Xiangzhen, and Chen Zhenwei, sourced from Chenming's Strategic Deep Thinking, original title: "A Preliminary Discussion on AH Premium by Guangfa Strategy Liu Chenming & Xu Xiangzhen," with some edits by Wall Street Insights.

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