The China equity market includes a myriad of share classes, each with distinct characteristics. ‘Offshore’ Chinese equities are listed on overseas stock exchanges such as New York and Hong Kong and denominated in foreign currencies, while ‘onshore’ Chinese equities are listed on the Shanghai and Shenzhen Stock Exchanges and denominated in RMB.
China’s onshore stock market, particularly the A-shares segment, is much larger than the offshore component, with more than 3,600 companies listed on the Mainland exchanges, compared to around 1,200 listed offshore.
Source: Hong Kong Exchanges and Clearing (HKEX), NASDAQ, as at 31 October 2018
Evolving China market access
Despite the size of China’s onshore equity market, its shares are largely underrepresented in global portfolios. A closed economy and a history of capital controls meant that foreign investors have, in the past, had little opportunity to participate in the market.
Although the launch of the Qualified Foreign Institutional Investor (QFII) programme in 2002 permitted a small number of overseas investors to purchase China A-shares, trading was subject to strict preapprovals, licenses and quotas.
Restrictions have eased over time; and by the time of the launch of the Renminbi-QFII programme in 2011, the number of qualifying investors and eligible securities had expanded significantly.
However, it was the 2014 launch of the Stock Connect platform which marked a stepchange for overseas investors. With Stock Connect, access to the China A-share market became much more straightforward.
Stock Connect provided a link between the Shanghai and Hong Kong stock exchanges, allowing foreign investors to trade selected A-share stocks on a daily basis without needing to apply for individual quotas, or be subject to minimum lock-up periods and capital repatriation limits. It also allowed Mainland investors to diversify their equity holdings and foreign exchange exposure by purchasing Hong Kong-listed stocks.
The launch of the Shenzhen-Hong Kong Stock Connect followed at the end of 2016; and at the same time, aggregate trading quotas were removed (but daily trading limits have remained). In early-2018, daily quotas quadrupled from RMB 13 billion to RMB 52 billion for Northbound trading; and from RMB 10.5 billion to RMB 42 billion for Southbound trading.
Stock Connect now covers around 80% of the market capitalization of the Shanghai and Shenzhen exchanges – or around 1,400 companies. Foreign ownership of China A-shares has risen steadily (total shareholding value of Mainland companies via Stock Connect has grown to RMB 621 billion1) and trading volumes have reached record highs.
1 Source: Hong Kong Exchanges and Clearing (HKEX) as at 31 October 2018
Note: USD 0.143 per RMB as at 31 October 2018
Stock Connect Average Daily Trading Volume (HKD bn)
Source: Hong Kong Exchanges and Clearing (HKEX), as at 31 October 2018.
China A-share inclusion in equity indices
Global investors can now choose to invest into the China A-share market via three market access mechanisms: QFII, R-QFII and Stock Connect. As a result, interest in the domestic China equity market has been growing.
In 2018, after a multi-year consultation period and a year-long planning interval, MSCI added approximately 230 China A-shares to the MSCI Emerging Markets Index over a two-phase process in May and August.
While the initial allocation was small – just 0.8% of the MSCI Emerging Markets Index and 2.3% of the MSCI China Index based on a 5% partial inclusion factor (PIF) – it represented an important milestone. A further consultation is underway, which could lead to a rise in the PIF from 5% to 20% for large-cap securities in 2019; ChiNext stocks to be added to the eligible exchanges in 2019; and mid-cap securities to be added in 2020.
According to MSCI data, Chinese equities could eventually comprise more than 40% of the MSCI Emerging Markets Index, with more than 13% weighted in China A-shares. For the MSCI China Index, the domestic equity component could increase to a third.
FTSE Russell, another major index provider, said that it would add China A-shares to its indices in three tranches starting from June 2019 and ending in March 2020. Inclusion would be based on 25% of the investable market capitalization of eligible securities, currently designated by the FTSE China A Stock Connect All Cap Index. After completion of the first tranche, China A-shares will comprise approximately 5.5% of the FTSE Emerging Index and 0.57% of the FTSE Global All Cap Index.
As two of the main benchmark index providers for the industry, these developments mark an inflection point for Chinese equities. Although full A-share inclusion is unlikely to happen quickly, the next five years should see a steady progression towards full representation.
As index weightings change to better reflect the relative size of the China equity market in terms of market capitalization and trading volumes, Chinese equities could eventually qualify as a standalone asset class.
What might happen in the next five years?
Source: MSCI, First State Stewart Asia, as of 1st June 2018. Forecasted weights for 20% and 100% inclusion have been extrapolated from MSCI data.
The broadening opportunity set
The total China equity market, including both onshore and offshore equities, contains plenty of high quality franchises and growth opportunities for bottom-up stock selectors to choose from. Chinese companies have delivered strong earnings growth in comparison to major global markets in the US, Europe, Japan and across the Asia Pacific.
Consensus 12-month earnings growth estimates2 for the Shanghai Composite is 13.4% at a valuation of 11.9x price-to earnings (P/E). In the offshore market, the Hang Seng Index is trading at around 10.1x forward P/E with estimated earnings growth of 10.0%, while the Hang Seng China Enterprises Index is trading at 9.0x P/E with a growth outlook of 10.8%.
2 Source: UBS Securities, Go-goal, IBES, as at November 2018
China has delivered strong historical earnings growth
EPS CAGR 2008-2017
Source: Bloomberg, First State Stewart Asia. Trailing weighted EPS growth as at 31 December 2017
A-share aggregate earnings (RMB bn)
Onshore vs. offshore
As investor portfolios might already include offshore Chinese equities, how would the inclusion of A-shares affect the asset allocation? Although there is some overlap – some companies are dual-listed with both an A-share and an H-share class – the broad-based A-share market covers a wider range of industry sectors and is considered to be more representative of the underlying Chinese economy.
For example, home furnishing retailers, housewares and general merchandise stores are exclusive to the A-share market, while others, such as food distributors and diversified real estate investment trusts (REITs) are part of the offshore H-share market, but are not in A-shares.
Within A-shares, there are also differences between the two main domestic exchanges. Due to historical reasons (proximity to then seat of government in Beijing, as well as being the hub for merchant trading since the late 1800s), state-owned enterprises (SOEs), large-caps and ‘old economy’ industries such as consumer companies, financials and manufacturers form the majority of the Shanghai Stock Exchange.
Meanwhile, the Shenzhen Stock Exchange, which includes the Main Board, the SME3 Board and the ChiNext Board, contains smaller to medium-sized companies; and includes a greater number of ‘new economy’ and technology stocks.
The ChiNext Board, in particular, is similar to the NASDAQ in the United States (or the AIM market in the United Kingdom) and allows fledgling growth companies to raise equity capital with more flexible listing requirements than the Main Board.
In the offshore market, H-shares are dominated by financials, mainly due to the major Chinese banks and financial institutions which chose to list in Hong Kong to raise capital outside of China. Red chips are skewed towards the energy and telecoms sectors, while P Chips and N-shares are predominantly focused on technology and consumer companies.
3 Small and Medium Enterprises
Note: Orange color indicated New China Sectors
Source: Wind, FactSet, Goldman Sachs Global Investment Research
China Indices - sector differences
Source: Bloomberg, FactSet, First State Stewart Asia, as at 31 October 2018.
A closer look at the MSCI China index and how it has evolved over the past 10 years highlight a few interesting observations. Historically, financials and energy companies were the largest constituents of the index.
However, more recent performance of the technology sector has boosted its relative weight in the index. Technology has now overtaken financials; and around a third of the MSCI China is now comprised of just three large tech companies: Tencent, Alibaba and Baidu.
Financials still comprise the second-largest segment of the index and together, almost 60% of the index is weighted to just these two sectors. We believe this reflects an unwelcome concentration of risk – and not truly reflective of the investment opportunities available to the unconstrained investor.
For illustrative purposes only. Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of First State Stewart or First State Investments.
10-year evolution of the MSCI China
Source: FactSet, First State Stewart Asia, as at 31 October for each corresponding year.
MSCI China Index
Top 10 weights over time
A few considerations
The China A-share market is still relatively young and, like the overall Chinese economy, remains heavily influenced and directed by the government. This has led to some market idiosyncrasies that investors should be aware of.
Firstly, market participants are mostly retail investors, often trading on margin accounts which provide financing to leverage an investor’s stock market exposure. Around 80% of the market (by trading volume) is comprised of small retail investors and day traders who tend to be more speculative and have a shorter-term mind-set. This is one of the key reasons for the A-share market’s heightened volatility.
To combat this, general stock prices are subject to daily up/down trading limits of +/- 10%, which restrict an investor’s ability to buy or sell securities during volatile periods. If a company’s share price hits the price limit (either up or down), trading is automatically halted until the following day.
Companies can also voluntarily suspend trading of their shares, in an attempt to ride out market volatility and avoid investor selling. During the stock market rout in mid-2015, more than half of all listed A-share companies suspended trading in an attempt to stem outflows.
During these periods of market volatility, state-owned banks and brokers are often conscripted into ‘national service’, with state-mandated trading designed to support stock prices. National service can also be called upon to lift market sentiment ahead of important dates in the political diary.
These interventions distort the price discovery mechanism and lead to an inefficient market over the shorter term. However, this presents an attractive opportunity for active investors to generate alpha – by investing over a longer-term time horizon, using a fundamentally-driven investment approach and employing robust valuation models to identify mispriced stocks.
First State China Funds Range
The funds referenced above are not available for investment by US persons. Reference to the funds is for informational purposes only and in no way is intended to offer the funds for purchase.
First State China Fund Range
Source: First State Investments, as at 31 October 2018
About the team
First State Stewart Asia is an autonomous investment management team within First State Investments, with offices in Hong Kong, Singapore and Edinburgh. The team manages US$23 billion (as at 30 September 2018) across a range of Asia Pacific and Global Emerging Market equity strategies on behalf of clients globally.
We are conviction-based, bottom-up stock selectors with a strong emphasis on proprietary research. Our goal is to identify high quality companies to invest in for the long term. We look for founders and management teams that act with integrity and risk awareness; and dominant franchises that have the ability to deliver sustainable and predictable returns over the long term.
We are conservative investors and define risk in terms of the permanent loss of capital, rather than deviation from any benchmark index. We believe that by investing in quality companies and holding for the long term, the risk to capital is greatly reduced.
In summary, our investment approach is based on:
- Bottom-up stock selection
- Quality companies
- Strong valuation disciplines
- Long-term investing
- Absolute return mindset
- Benchmark indifference
This material is solely for the attention of institutional, professional, qualified or sophisticated investors and distributors who qualify as qualified purchasers under the Investment Company Act of 1940 and as accredited investors under Rule 501 of SEC Regulation D under the US Securities Act of 1933. It is not to be distributed to the general public, private customers or retail investors in any jurisdiction whatsoever.
This presentation is issued by First State Investments (US) LLC (“FSI” or “First State Investments”). The information included within this presentation is furnished on a confidential basis and should not be copied, reproduced or redistributed without the prior written consent of FSI or any of its affiliates.
First State Investments funds are not registered for sale in the US and this document is not an offer for sale of funds to US persons (as such term is used in Regulation promulgated under the 1933 Act). Fund-specific information has been provided to illustrate First State Investments’ expertise in the strategy. Differences between fund specific constraints or fees and those of a similarly managed mandate would affect performance results. This material is provided for information purposes only and does not constitute a recommendation, a solicitation, an offer, an advice or an invitation to purchase or sell any fund and should in no case be interpreted as such.
Any investment with First State Investments should form part of a diversified portfolio and be considered a long term investment. Prospective investors should be aware that returns over the short term may not match potential long term returns. Investors should always seek independent financial advice before making any investment decision. The value of an investment and any income from it may go down as well as up. An investor may not get back the amount invested and past performance information is not a guide to future performance, which is not guaranteed.
Certain statements, estimates, and projections in this document may be forward-looking statements. These forward-looking statements are based upon First State Investments’ current assumptions and beliefs, in light of currently available information, but involve known and unknown risks and uncertainties. Actual actions or results may differ materially from those discussed. Actual returns can be affected by many factors, including, but not limited to, inaccurate assumptions, known or unknown risks and uncertainties and other factors that may cause actual results, performance, or achievements to be materially different. Readers are cautioned not to place undue reliance on these forward-looking statements. There is no certainty that current conditions will last, and First State Investments undertakes no obligation to publicly update any forward-looking statement.
PAST PERFORMANCE IS NOT INDICATIVE OF FUTURE PERFORMANCE.
Reference to the names of each company mentioned in this communication is merely for explaining the investment strategy, and should not be construed as investment advice or investment recommendation of those companies. Companies mentioned herein may or may not form part of the holdings of FSI.
The comparative benchmarks or indices referred to herein are for illustrative and comparison purposes only, may not be available for direct investment, are unmanaged, assume reinvestment of income, and have limitations when used for comparison or other purposes because they may have volatility, credit, or other material characteristics (such as number and types of securities) that are different from the funds managed by First State Investments.
Apart from First State Investments, neither the Commonwealth Bank of Australia (the “Bank”) nor any of its subsidiaries are responsible for any statement or information contained in this document. Neither the Bank nor any of its subsidiaries guarantee the performance of any fund or the repayment of capital by any fund. Investments in a fund are not deposits or other liabilities of the Bank or its subsidiaries, and the fund is subject to investment risk, including loss of income and capital invested.
For more information please visit www.firststateinvestments.com. Telephone calls with FSI may be recorded.