China A-shares: the opportunity for investors

As the initial epicentre of the new coronavirus (Covid-19) outbreak back in January, China has also been the first country to ease lockdowns and other containment measures. As a result, Chinese stocks have held up better than most other global equity markets on a year-to-date basis; and this has spurred investors’ interest in China equities.

Of course, an investment strategy should not be based on short-term developments, especially as the ultimate effects of the coronavirus crisis are still unclear. That being said, there are good reasons why Chinese equities, specifically the mainland markets of Shanghai and Shenzhen, offer attractive opportunities to investors looking to strategically position their portfolios for better times.

A recap on China A-shares

Once completely excluded from global benchmarks, China A-shares have now made their way into major benchmark indices, which include the widely-followed MSCI suite of indices. This has been the result of a gradual opening-up of China’s capital markets to foreigners. Since mid-2017, the proportion of A-shares in MSCI’s indices has increased in a phased manner. Despite this significant development, the exposure investors get is limited and possibly not optimal.

Currently, 20% of the total market capitalisation of 472 A-share stocks is included in the MSCI Emerging Markets Index. As such, the inclusion factor is relatively low, as there are over 3500 stocks listed on the Shanghai and Shenzhen stock exchanges.

Furthermore, the STAR board, launched in 2019 as China’s version of NASDAQ, is completely excluded from the MSCI indices. That is why the MSCI China Index is still dominated by stocks listed in Hong Kong SAR (H-shares, P-chips, Red-chips) and the US (American Depositary Receipts - ADRs), making up 35.8% of the MSCI Emerging Markets Index, while the share of the much larger A-shares market is only 4.8%, as seen in the chart below.

The timeline for further increasing the inclusion factor for China A is uncertain. However, the direction of travel is clear and over time, the significance of the A-share market is likely to increase.

Why should investors consider a greater A-shares allocation?

The key downside of sticking to benchmark indices to gain China equities exposure is limited alpha opportunities; given that the A-shares market has been a fertile ground for active managers.

Based on our calculations, the median China A-shares manager has delivered an 8% annualised excess return over the five year period to end of March 2020[1]. This is an unprecedented level of alpha compared to other global markets, and can result in a situation where the index return is negative but a manager’s return is positive.

As always, past performance is not a guide to future performance. But there are clear reasons we wrote about in our paper last year that make China A shares unique among its global peers. We highlight three of them below.

1. High retail investor participation

The defining feature of the A-shares market is the high level of participation from retail investors, who account for more than 80% of the average daily trading volume. This is in stark contrast to the H-shares market in Hong Kong SAR, which is dominated by large institutional investors.

Why is this important? As retail investors are generally less focused on company fundamentals, and often trade on rumours, it can result in stocks being significantly under or overvalued. Hence retail investor dominance provides significant opportunities for more sophisticated investors with rigorous investment processes. These investors can take the other side of a trade and be rewarded for correcting the mispricing.

For example, in early 2019, large retail flows went into ‘industrial marijuana’ and ‘red or state media’ themes. This was despite there being little fundamental backing for these themes.

The longer time horizon of institutional investors also allows them to withstand the fluctuations in prices caused by wild swings in retail sentiment.

For example, Sanhua Intelligent, a Chinese manufacturer of air conditioning and refrigerator components, has seen its share price fluctuate widely in the last few years, as it has fallen in and out of favour with speculators. Still, the share price has more than doubled since mid-2019. This is because Sanhua produces the heat exchange system used in Tesla electric cars and other next generation electric vehicles. The demand for such parts has been growing steadily, giving institutional investors the confidence to stay put as the retail crowd trades in and out.

2. Fundamentals are becoming more important as the market matures

If markets were driven solely by speculation, it would be very hard for even the best investment strategy to add value. The good news is the A-shares market is maturing, and fundamental factors are becoming more important in differentiating the performance of stocks. This is the sweet spot for an active strategy.

The charts below show the total return of the MSCI China A Index, broken down into quintiles based on return-on-equity (ROE) and price-to-earnings (P/E) ratios of individual stocks. Before 2015, there was little differentiation in the performance of either factor, highlighted by the clustering of returns. This means that investors were not rewarded for buying cheap stocks or stocks with high ROE.

In the last three years, however, there has been a visible shift with return dispersion increasing significantly. The stocks with a high ROE have outperformed the stocks with a low ROE. In the same vein, cheap stocks have outperformed expensive ones. The efforts of fundamental investors are now being rewarded by the market, as valuations and corporate profitability are gaining a greater influence on returns.

Returns in the A-shares market are now more driven by fundamental factors:

3. The A-shares market has a long tail of mid-cap stocks

Compared to the offshore parts of the market (Hong Kong SAR and US listed stocks which are included in the MSCI China), the market capitalisation of A-shares is more evenly distributed, with a long tail of mid cap stocks. While these companies might be less known to international investors than tech giants such as Tencent and Alibaba, they are no less part of the China growth story.

Importantly, investors can access companies in sectors that are otherwise unavailable in the offshore market. This includes sectors such as consumer goods (home furnishing retail, housewares & specialities, homebuilding), consumer services (travel & leisure), consumer staples (distillers), industrial automation, media and broadcasting, and healthcare.

Furthermore, the smaller stocks often have limited coverage by sell-side analysts, leading to information inefficiency. In fact, one-third of the market is not covered by analysts at all. Compare this to the US where there are on average 21 and 11 analyst ratings per large and mid cap stock respectively, according to the Bespoke Investment Group.

Wide stock selection and low coverage are two prerequisites for successful stock picking.  

Naturally, poor liquidity conditions could prevent investors from fully taking advantage of these opportunities. However, the A-shares mid cap stocks are actively traded, allowing investors to deploy capital.

How should investors approach A-shares?

In uncertain times, it is important to look at the bigger picture. We believe that the unique characteristics of the A-shares market warrants a satellite A-shares allocation, in addition to a global emerging markets mandate.

Such an allocation would allow investors to access a much larger portion of the A-shares market, as measured by the number of stocks and their market capitalisation. The broader opportunity set is necessary to reap the full benefits, especially the large alpha opportunities.

Despite the improvements in recent years, there are still some issues with corporate governance in China. That is why it is paramount that a manager has the ability to carry out proper due diligence. This requires having boots on the ground, as well as understanding the language and local customs.

While these benefits can be available in a broad emerging markets strategy if a manager has the local capability, the satellite approach would significantly widen the breadth of the analysis.

[1] Source: Schroders, Morningstar. Five years to 31 March 2020. Includes open-ended EAA China Equity A Shares funds. Returns are shown net of fees.