By China Equities Team
Skillful equity investors have the scope to position for sharp changes in market thinking and to be rewarded if these positions are proved to be correct. In the Chinese equity market in particular, with its very high proportion of retail ownership by international standards, a focus on fundamental, industry and company research and taking advantage of unconventional sources of information can be rewarded. Looking to identify industry leaders that will benefit as China transitions towards a consumer based, services led economy can help to uncover investment opportunities.
When index provider MSCI began including onshore China A shares in its flagship indices last year, global investors finally had a roadmap to follow into the long-restricted market for RMB-denominated mainland China equities. MSCI’s inclusion of A-shares in its index beginning in 2018 sent three key messages to global investors: that reforms have successfully opened up China’s equity markets; that the water is ‘safe to swim’; and, that Chinese equities now become a mandatory, rather than optional, investment. The influx of investments (exhibit 1) into Chinese equities, much of it in market capitalization-weighted indices, creates opportunities for active investors who have on-the-ground insight.
Exhibit 1: Overseas Investors' Onshore Holdings in China, Fixed Income & Equities (RMB Trillions) Jan 2016-Dec 2018
Passive indices: Capturing the past instead of the future
While China’s GDP growth rate has fallen from the highs of the early 2000s, it is still one of the fastest growing economies in the world and is expected to contribute an estimated 33% of global GDP growth in 2019, according to IMF numbers. As its economy continues its shift from a government-led fixed asset investment economy to a more services-led economy, we expect the quality of growth, the efficiency of the economy and, consequently, cash flows and profitability to improve.
Much of this growth will come from companies that have sprung up to serve the new economy. Meanwhile, much of China’s debt resides in its old-economy, state-owned enterprises (SOEs), which we believe are over-represented in benchmark indices. This leads investors to believe there is a debt crisis. In contrast, privately owned companies (POCs) in China have healthier debt-to-asset ratios and tend to be more profitable (see exhibits 2 and 3).
Exhibit 2: Return on assets for industrial enterprises
Exhibit 3: Private companies have healthier corporate balance sheets
By just about every measure, POCs have done far better than SOEs in recent years. Privately owned companies are heavily concentrated in the new-economy, consumer-driven sectors that we believe will continue to grow at a faster pace than developed markets over the next several years.
If you look at future growth indicators such as sales growth and cap-ex spending, POCs look much better than SOEs. Earnings growth has been much stronger for POCs than SOEs over the last five years, and we expect this trend to continue (see exhibit 4).
Exhibit 4: New-economy privately owned companies (POCs) vs. SOE and old-economy POC earnings CAGR 2012-18
We believe that an active allocation gives investors a better chance of capturing growth opportunities offered by small and mid-sized companies in China than a generic allocation within an EM strategy.
The importance of selecting industry leaders among sectors and single stocks
One example of consumer-driven growth is the education sector, where we see opportunities for companies offering after-school tutoring in the K-12 age range. China’s market for education, and particularly for after-school tutoring, is both large and growing. It is also fragmented, and some of the larger firms in the sector have the opportunity to add market share because they are better resourced than smaller players.
We also see long-term drivers for China's healthcare sector. Healthcare spending per capita in China is still very low by international standards according to the World Health Organisation. Additionally, China's population is getting older. Finally, the healthcare industry in China is going through a process of rationalization. These themes, as well as fundamental trends like urbanization, automation, population ageing, and the rise of the services sector are long-term in nature and we believe that by identifying and investing in leading companies within these trends, we can deliver growth for investors over the long term. (Exhibit 5).
Exhibit 5: Chinese retail investors dominate China A-share trading compared to other major markets
The active advantage
An active approach, supported by on-the-ground, bottom-up research, may cherry-pick the best opportunities in these fast growing, emerging sectors in China before they are discovered by index-linked passive investment strategies. Proprietary research by analysts with deep understanding and a presence in the market is crucial.
Keys to success in the Chinese equity market
- Do not let benchmark weightings drive investment decisions. We believe Chinese market indices are behind the curve in recognizing the growing importance of private enterprise. Focus instead on identifying long-term winners.
- Don’t rely too much on sell-side research. Proprietary research by analysts with deep understanding and a presence in the market is crucial.
- Take a long-term view. Look for a dominant player (or players) in key industries.
China equity market share classes
It is important to understand the different classes of Chinese shares in order to understand the new opportunities in the market. China’s different share classes have different dynamics because of foreign exchange control, different market structures and different market participants.
Across its several classes of shares, the market capitalization of China’s stock market stood at around USD 6.5 trillion at the end of 2018. China’s various share classes have hampered foreign investment, particularly in some of the fast-growing private sector companies.
Chinese companies that are incorporated and listed in the People's Republic of China (PRC) generally issue A-, B- and H-share classes. Depending on where they are listed, these Renminbi (RMB)-denominated shares may trade in different currencies.
Chinese companies that are incorporated and listed outside of the PRC may be referred to as Red chips, P chips, N-shares or ADRs, depending on their revenue sources and listing location.