Access China

Experts from Schroders discussed these challenges and solutions in an article for Asia Asset Management. Jack Lee, Head of China A-Share Research and Angus Hui, Fund Manager, Asian Fixed Income shared their views and opinions on the topic.

Offshore listed Chinese equities have traditionally been the investable universe of choice for international investors seeking exposure to China and its economic growth story.

Meanwhile, the onshore markets over the years have also been increasingly made accessible via the QFII and RQFII schemes as well as the recently launched Stockconnect Scheme. More recently, MSCI’s inclusion of China A-shares has led international investors to reassess their existing China exposure.

Not only is the China A-shares market the second-biggest worldwide after America’s, it’s also home to some of the most innovative and fast-growing companies in the technology, industrials and consumption sectors as China continues to rebalance its economy.

Jack Lee, head of China A-share research at Schroders highlights key factors around valuation of onshore Chinese equities:

  • Capital source – In the A-share market, prices are largely driven by domestic capital (local investors) while in Hong Kong, or US ADRs, liquidity is mostly provided by foreign investors. The reality is that domestic investors have limited options if they want to invest overseas – given capital controls – and therefore the domestic market benefits. Based on this, the market should be priced according to what domestic capital is willing to pay and not on the outside perspective.
  • Dual-listed comparisons – So far only 97 stocks are duallisted in both the A-/H-share markets. Although the latest figures suggest that these names are trading at over 20% premium right now, there are more than 3,300 stocks listed in the China A-share market. It is far too simplistic to generalise with sweeping assumptions that this or that company’s valuation in the A-share market is not justified.
  • A-share market liquidity – The A-share market generally boats better liquidity than Hong Kong (perhaps with the exception of large cap giants) while trading turnover is also more evenly distributed and less concentrated – which should warrant some sort of premium.
  • Vastly different market structures – We cannot compare directly two different markets based simply on a multiple. For example, take the CSI300 and HSCEI which trade at PE multiples of 14x and 9x respectively. Whereas the former has a large proportion in mid-cap stocks, the latter has just 50 stocks and is concentrated in financials, with nearly half the index being made up of only four stocks. With the reshuffling of the CSI300 Index over time, the ‘new economy’ should be better represented – which is something Hong Kong’s market sorely lacks.
  • Better capital, better quality – A-share IPOs tend to be smaller scale, with large fund-raising actually coming in secondary placements. The screening process for mid-cap IPOs in China sees companies being scrutinised closely by the authorities. Arguably it is a tougher market to list in compared to Hong Kong’s market-based registration system and this more amenable fund-raising environment allows mid-caps to grow larger.

Dealing with debt

China’s fixed income market is of growing interest to investors too, but how should investors take into account China’s debt pile? China’s central bank is taking steps to rein in previous excess and fears over an eventual debt implosion seem to have receded for now. Yet is it doing enough and does this improvement bode well for China’s credit market?

Angus Hui, fund manager, Asian fixed income at Schroders says: “The People’s Bank of China has carried out the bulk of its interbank liquidity squeeze and we believe the worst is now behind us. The authorities have had some success in deleveraging – evidenced by a falling M2 money supply that has hit a multi-year low – while recent data on total social financing (TSF) has also been positive.

“In fact, we are seeing encouraging signs that state-owned enterprises (SOEs) are beginning to deleverage on the back of a strong recovery in profits aided by supply-side reforms. This is particularly true in industries which are experiencing overcapacity issues.

“Overall, we remain positive on the Chinese bond market given the relative value that both onshore and offshore Chinese bond yields are offering investors (versus global bond yields).

“The slowdown in growth momentum since July was expected given it came on the back of a cooling property market and financial leverage crackdown by regulators.

“On the onshore credit front, although quality does remain a concern, default rates have so far been very low and are mainly in industries hit by overcapacity. That said, we do expect a pickup in defaults and as a result favour high quality issuers.”

Important Information: This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks. This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.

Source: Asia Asset Management December 2017/January 2018

Duncan Lamont, Head of Research and Analytics shared his views and opinions on the topic.

At 15% of the global economy and a similar size to the eurozone1, China is hard to ignore. Yet, while its financial markets are also significant, they have to date been largely inaccessible to overseas investors. In this paper we look at how investing in China stands currently and a number of possible ways that this might evolve over time. We also draw out some of the obstacles that stand in the way of further integration with world markets. Whatever the path and end point, it appears highly likely that China will represent an increasing part of major equity and fixed income benchmarks. How should investors respond? Benchmark providers are not masters of the universe so being governed solely by their moves strikes us as illogical. The appropriate course of action will depend on a number of developments, as we set out in detail in this paper. This paper also highlights a number of areas which merit closer investigation and which we will cover in subsequent work.

China punches below its weight in global capital markets…

China’s debt market is the third largest in the world at around 8% of the global market2, while its equity market is around 9% of the global universe3. However, only a small proportion of these markets is currently accessible to international investors. Chinese equities represent a mere 3% of the free-float-adjusted MSCI All-Country World Index and its bonds barely half a percent of the Bloomberg Barclays Global Aggregate index (Figure 1). Meanwhile, its local bond market, valued at over $9 trillion, is excluded entirely from the main fixed income benchmarks.

…but things are changing

The key reason that Chinese assets are so poorly represented in major benchmarks is that the Chinese authorities have wished it to be so. Stringent regulations restricting foreign ownership of Chinese companies and tight currency controls have made it incredibly difficult for international investors to access local Chinese markets. Chinese state motivations have been grounded in a desire to maintain control and over genuine concerns about stability of the currency and economy if their markets were to be opened more fully. Local Chinese asset markets have not been easy to invest in and thereby fail a key test of a good benchmark. However, as described later, this is changing. This has been most notable in equities and has already resulted in the symbolically important move by MSCI to announce that it would include an, admittedly very small, initial allocation to local Chinese equities in its flagship benchmark indices. The early stages of progress are now also being seen in the fixed income market.

Figure 1: China is remarkably under-represented in global indices

The major global equity benchmark is the MSCI All-Country World Index; the major global fixed income benchmark is the Bloomberg Barclays Global Aggregate.

GDP data cover 2016 calendar year; share of global equity universe is as at June 2017; share of global fixed income universe is as at fourth quarter 2016; weights in major equity and fixed income benchmarks are as at 31 July 2017. Source: Bloomberg, IMF, MSCI and Schroders.

 

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1 International Monetary Fund, based on 2016 GDP in current dollar terms
2 Bank of America Merrill Lynch, as at fourth quarter 2016
3 Bloomberg and Schroders, June 2017

 

 

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Experts from Schroders discussed these challenges and solutions in an article for AsianInvestor. Jack Lee, Head of China A-Share Research and Chris Durack, CEO of Hong Kong and Head of Institutional Asia Pacific shared their views and opinions on the topic.

China A-shares' diversity and rapid growth require an 'All-China' approach

China’s booming consumption growth, unique culture and rapid technological advancements means that the onshore A-share market, which has a market value of more than US$7 trillion, offers exclusive and diverse investment opportunities not found in offshore listings, according to Schroders.

With the Stock Connect scheme which first started in 2014 and expanded in 2016, global investors can now access more than 1,560 out of over 3,000 stocks listed onshore in China. This compares with 225 H-shares and under 300 ADRs traded in U.S. stock exchanges and over-the-counter (OTC) markets.

According to Jack Lee, Schroders’ Shanghai-based Head of China A-shares Research, unlike some offshore listings, the A-share market is home to some of China’s most innovative and fastest-growing companies that are more aligned with China’s economic expansion. These economic developments include the trend towards consumption of higher-grade products, increased healthcare spending and the rise in the number of high-tech related software and hardware companies. “There are some industry leaders that are related to the economy that are not listed in the offshore space and these include prominent home appliance makers and retailers and major China’s liquor, tourism and media companies,” adds Lee.

The recent addition of the Shenzhen market to the Stock Connect scheme in particular makes available many new, small and mid-cap “growth stocks” in fast-growing sectors such as IT, science, healthcare and technology, says Lee.

About 75 percent of the companies in Shenzhen are non-SOEs (state-owned enterprises), presenting interesting and emerging investment opportunities for global investors, based on Schroders’ analysis. Schroders’ 19 strong Greater China investment team consists of four fund managers in Hong Kong, and 15 research analysts based in Hong Kong, Singapore, Taipei and Shanghai.

MSCI inclusion signals maturing of A-share market

This diverse offering comes against a backdrop of continuing maturity and development of the Chinese stock market as well as efforts by the government to ease capital controls. Among the breakthrough events that signalled China’s growing significance in the stock market is the prospective inclusion of approximately 222 stocks in the MSCI Emerging Market Index in May and August next year. Last year, the International Monetary Fund (IMF) added the RMB to its special drawing rights basket, and Chinese equities were also partially included into the FTSE Russell indices.

“MSCI’s five percent inclusion factor for currently qualified A-share listed stocks is just the beginning,” says Lee. “China’s stock market is growing very rapidly; this year there are some 300 to 400 IPOs (Initial Public Offerings); institutional investors can no longer ignore this market.”

Global norms may not apply

Given such a large market, there is no lack of choices but the flip side is how to identify the winners from the laggards, says Lee.

“In a fast-growing economy, the boom and bust cycle can be relatively short,” explains Lee. “A company that is regarded to have a stable business model with steady cash flows and yields could be disrupted within a short period and we have seen many cases like these over the last decade.”

Lee also advised investors to keep an open mind about valuation. China’s fund-raising environment, government rules and approval processes are sometimes friendlier than more established markets. 

“You can’t compare horizontally across the same industry because the external environment is different. The cost of capital is different in every market,” says Lee. “A company that is trading at a premium in China could well be deserving of that premium,” he adds.

China A-share market brings further diversity to global investors

Source: Bloomberg, Factset, HKEx, compiled by GS Securities Division. Data as of 4th May 2017.

Governance a key focus of Schroders' ESG consideration

To identify good quality companies, Lee says Schroders takes an active fundamental approach is to seek out entities with high quality management and those that meet the investment manager’s ESG (Environmental, Social and Governance) criteria.

“While we are seeing the E (Environmental) being considered increasingly by companies in China; S ( Social Responsibilities) to a lesser extent; the focus here is really on G ( Governance) ,” says Lee, adding that an encouraging sign is that Chinese companies have consistently made improvements in corporate governance in recent years.

Another factor that should be taken into consideration while identifying quality companies is that management’s interests should be aligned with both the majority and minority shareholders. “If the interests are aligned, then you would believe that they will work hard to make profits for the minorities.” Companies should also be focused on Research and Development, he adds.

Two key investment themes

Lee has identified two key investment themes: China’s consumption upgrade trends and its high-value tech industry.

“Consumption upgrade is a pronounced trend. Chinese consumers are becoming increasingly sophisticated, and many are willing to pay a premium for better quality products and services,” say Lee. He adds that “traditional companies that are selling products to satisfy basic needs might not do as well as companies who can differentiate themselves by introducing high-value products, offering better branding and product features.”

According to data from the National Bureau of Statistics, consumption contributed 77.2 percent to economic expansion in the first quarter, up from 64.6 percent the prior year.

Another growing industry is China’s technology sector. In the next decade, China will see an abundance of quality workers as millions graduate from tertiary education. “This highly-skilled labour is the supporting pillar that will help propel growth in the tech sector,” says Lee.

The Chinese government has also been supportive of the technology sector. The State Council said in a statement in August that the government plans to expand the scale of IT consumption by 11 percent a year to 6 trillion yuan ($900 billion) by 2020, and this includes demand for digital products such as drones and wearable devices for services such as online medical consulting, entertainment and travel booking. 

“Certain technology manufacturers that are competitive are only listed on the mainland,” says Lee. He singled out companies that produce and distribute battery materials for electric vehicles as conventional combustion-engine cars will likely be phased out in the next decade.

A-shares' technology offering

In fact, a comparison of the sectors listed in the offshore markets, including ADRs, H-shares, Red-Chips (China-based companies incorporated internationally and listed on the Hong Kong Stock Exchange) and P-Chips (Chinese companies listed on the Hong Kong Stock Exchange which are incorporated in the Cayman Islands, Bermuda and the British Virgin Islands), showed that A-shares offer the widest variety and highest number of IT companies.

Consider an "All China" approach

Going forward, mainland stocks will inevitably play an increasingly integral role in asset allocation for global investors as China A-shares gain prominence with the gradual structural changes introduced by the government.

“As investors weigh up their investments in China and contemplate investing directly onshore in A-shares, it is important to note that China’s two domestic stock exchanges in Shanghai and Shenzhen offer the largest equity markets in Asia, and are second only to the US markets in terms of size and trading volumes globally,” says Chris Durack, CEO of Hong Kong and Head of Institutional Business, Asia Pacific.

“In ensuring that investors continue to be presented with the most relevant investment opportunity set in China, we believe an “All China” equity approach should be considered. A relevant approach is to consider a benchmark mix of the MSCI China and MSCI China A,” Durack adds. “In this regard, Schroders’ deep experience makes us ideally placed to help our clients with tailored solutions,” he says.

Important Information: This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks. This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.

Source: AsianInvestor October/November 2017

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