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Chinese equities: An investment opportunity

28th February, 2020

The Chinese equity market is enormous and its liquidity has improved in recent years.  It is valued more cheaply than developed markets and is under-owned by both domestic and foreign investors. We believe that this situation will improve in the future, and in the meantime that domestic Chinese equities offer an opportunity for higher return generation.  China is not just an engine for global economic growth, it is home to multiple secular trends, which makes it an ideal place for stock-picking.

Panda in the room

China’s growth over the past several decades has been referred to as an economic miracle: since its economic reforms began in the late 1970s, China has been the fastest growing economy in the world.  In the past decade China became the largest contributor to world growth and is expected to provide one third of global gross domestic product (GDP) growth going forward. Meanwhile the Chinese stock market has developed to become one of the largest in the world by size and turnover, second only to the US.  We note that economic growth and stock market returns are not the same thing.  However Chinese companies are trading at a significant discount to US stocks, and many offer exposures to attractive industry trends.

Gaining some weight

China has been gradually reforming and opening its capital markets to foreign investors. In response, global benchmark providers began to gradually incorporate Chinese assets.  This inclusion still remains very small compared to the actual size of Chinese capital markets.  Meanwhile, domestic retail investors have been under-owning risky assets and parking a large portion of their savings in real estate, a trend which is likely to change as they gain more investment experience.  We believe that China is under-owned by both domestic and foreign investors, and along with the aforementioned trends this is likely to support investor flows into Chinese stocks and an improvement in the efficiency of Chinese markets.

China A-share: “A” is for active

Historically, Chinese stocks have been listed in China, Hong Kong and the US; the latter two being significantly more developed markets.  The name “A-share” refers to domestic Chinese companies listed on the Shanghai and Shenzhen stock exchanges.  Unlike those listed in Hong Kong and the US, the China A-share market is dominated by retail investors which, unlike institutional investors, have stronger tendencies towards short-termism and a herd mentality. This behaviour, combined with poor analyst coverage and more difficult data quality, creates opportunities for discerning active investors. Notably, passive funds tend to be less effective in the China A-share market as volatility tends to reduce returns.

China is trending

China’s growth potential has been a topic of much debate, which often focusses on the historic growth model of exports and debt-fuelled industrial investment and construction.  However various secular trends have emerged in the region such as: a growing middle class, digitalisation, financial reform and the opening of the services sector.  These could be the key drivers of future growth. 

China is no longer just a manufacturing capital of the world.  The service industry has become the top choice for foreign investors in China, while the Chinese middle class and Chinese tourists have become an investment theme on their own, driving up prices of hotels, airlines, travel companies and retail stocks globally.  China has become a global leader in e-commerce, as they catch up with developed peers in terms of internet and mobile payments penetration.  Robotics and artificial intelligence are newer industries where China is already positioning for the future.

What are the risks?

While these secular trends can be the key drivers behind future growth, there are of course risks.  The enormous total debt level, which is now above 300% of GDP, is a concern, and a slowdown in global trade and technology would dent the economic prospects.  To reduce the risk of a “hard landing” scenario, the Chinese government has been active with a range of fiscal and monetary stimulus measures.

Though Chinese companies have been making progress in addressing environmental and corporate governance issues, these matters remain a sticking point for many investors.  We believe that this risk can be mitigated by choosing an active manager over a passive fund.

Finally we note that there will always be wild card risks, such as the corona virus, and therefore we stress that this is not a tactical call on the near term outlook.  Rather it is taking a multiple year view on the prospects of a skilled active stock-picker to find attractive opportunities in China.

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