MSCI’s recent decision to increase the weighting of China A Shares in its indices1 will lead to inflows worth a predicted USD73 billion in 20192 into the stock exchanges in Shanghai and Shenzhen. Active investors will be entering the market to capture investment opportunities in one of the world’s fastest growing economies. Some of these investors will have experience allocating to onshore China, while others will be new to the market. All of these money managers however, will be striving for alpha returns that exceed the broader benchmarks.

    Alpha vs Beta

    The importance of alpha in China A Shares is evident when it is compared with beta returns. Over the last ten years, China’s main benchmarks have returned only 3 per cent a year, compared to 14 per cent in the US, reversing a long term trend where China’s outperformed the US, said Victoria Mio, Co-Head of Asia Pacific Equities and Chief Investment Officer for China at Robeco.

    The turning point occurred around the time of the Global Financial Crisis, she said, when global demand plummeted and China accelerated its transition from an export-driven economy towards one where domestic consumption became more important. Many listed companies in traditional industries failed to adapt. 

    “The broad Chinese market is dragged down by these problematic companies, due to the poor delisting mechanism,” she said. “In the US, only competitive companies can stay listed.”

    She was speaking as a panellist at HSBC’s recent China Conference, which assembled investors from Chinese both domestic and international asset management firms for a panel discussion that focused on how best to find returns in China A Shares. 

    Many of the poorly performing companies are large-cap companies that have significant weighting in the index, so to find returns that beat the benchmark investors are required to go beyond the index heavyweights and look for smaller companies that have attractive growth potential in sectors like consumption and technology. Many of these companies can be found on the Shenzhen bourse, where 81 per cent of listed companies are small or medium cap stocks3

    “As China shifts to high-quality growth, we can see the country emerge as a leader in a number of new industries,” said Li Quansheng, General Manager of Equity Investment at Bosera Asset Management. “A leading company in a new industry can have a RMB10 billion valuation in its early stages. When you next they can quickly grow to a valuation of RMB100 billion or even higher. So there are clearly opportunities to find companies that can provide significant alpha”. 

    Dealing with high valuations

    The problem with attractive companies in growth industries is that their stocks tend to trade at valuations much higher than the broader market. An investor therefore needs to buy in before everyone else does or face the dilemma of whether or not to buy into what appears to be an expensive stock. 

    The panel talked about how to assess a company with a high price-to-earning ratio, and they discussed the importance of looking at the current valuation in light of its future prospects – as a seemingly expensive stock can still have strong growth potential. 

    But at the same time, investors should take a cautious approach towards expensive stocks. “Before buying into a company, do the necessary fundamental analysis and assess its future value,” said Mr. Li. “Invest a little at first if it is an expensive company, so you can observe the trend and assess how it will perform going forward.”

    Despite the focus on fast growing companies, cheaper companies should not be ignored, as value investing is a viable approach to China A Shares. Robeco’s Ms. Mio highlighted that since 2000, companies with a lower PE ratio have tended to outperform the market, and over the last ten years buying cheap stocks has proved to be a winning strategy. But going forward, she said that companies in new industries will be more attractive from a profitability perspective. 

    Navigating risks

    The panel also discussed the potential pitfalls that investors can face in the China A Share market. They talked about how investors should go beyond profit and loss and look a company’s cash flow to see whether the business has enough money to sustain itself. They also highlighted the importance for investors to check whether a company has pledged its shares as collateral for loans.  

    Han Xian Wang, Chief Economist at China Universal Asset Management, pointed to two more areas of concern. For a start, the penalties given out for breaking securities laws are too light, he said, and the rules need improving. Another issue he highlighted is the local investment culture, where investors tend to overlook warning signs and run into trouble. 

    “If a company is too good to be true, then it probably is not real. You have to do the research,” said Mr. Han.

     

    MSCI Press release

    2 HSBC Monthly China Insights on Chinese equities

    ibid

    Asset Allocation: China’s place in a global portfolio
    With access to onshore Chinese securities easier than ever before, investors are considering how best include the country into their existing portfolios.
    Join the conversation?

    Join our Linkedin group to get an unparalleled view of macro and microeconomic events and trends from a bank that is a leader in both developed and emerging markets.