How to build an A-list out of (China) A-shares

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1 MARKETS How to build an A-list out of (China) A-shares Better access to China s mainland equity exchanges may help diversify a global investor s portfolio, but this goes hand-in-hand with a thorough analysis of the individual companies being considered. Regina Chi, CFA Vice-President and Portfolio Manager AGF Investments Inc.

2 The inclusion of Chinese A-shares to MSCI s various indices is a landmark event that opens up the world s second largest stock market to a growing number of global investors. But the opportunities to buy stocks listed on China s mainland exchanges will remain limited over the next few years and it will take time before they become a more significant part of our diversified strategies focused on the developing world. Starting this past June and continuing in September, MSCI plans to add 233 A shares out of an approximate 3,500 names that are presently listed on both the Shanghai and Shenzhen domestic markets. This will represent just less than 1% of the global indexer s emerging market benchmark, with greater weightings happening over time and eventually leading to full inclusion of the A-Shares market some eight to ten years from now. The A-shares being chosen for inclusion this year are predominantly large and mega capitalization stocks with high earnings and dividend yield(s), low volatility and low beta. More mid-to-small cap names will likely be added over time to better reflect the overall size characteristics of China s domestic market, but MSCI said it still has a number of considerations to make in its inclusionary process going forward. Namely, it wants to see greater alignment of the A shares market with international market accessibility standards, as well as relaxation of daily trading limits, continued progress on trading suspensions, and further loosening of restrictions on the creation of index-linked investment vehicles. A-shares vs. H-shares? See appendix to learn more Potential Inclusion Roadmap Weighting in MSCI Emerging Markets China offshore China A 0.8% 7.4% 13.7% 30.6% 28.5% 26.6% 68.7% 64.1% 59.7% Sept Partial inclusion (IF=5%) 3-5 years (CGS-CIMBe) Partial inclusion (IF=50%) & addition of mid-cap 8-10 years (CGS-CIMBe) Full inclusion (IF=100%) Potential fund inflow US$18bn US$166bn US$303bn Sources: CGS-CIMB Research, MSCI, Bloomberg. As of May 4,

3 Given this gradual road map to full inclusion, investors will need to carefully weigh the characteristics of the A-shares market and potential advantages of its listed companies against the backdrop of a much vaster pool of opportunities in other emerging markets. For starters, the Shanghai and Shenzhen exchanges include many unique sectors that are not easily accessible through offshore listed equities (i.e. traditional Chinese medicine) and combined have a greater weighting in industrials, consumer goods, basic materials and health care stocks than the Hong Kong (H-shares) market. At the same time, A-shares may be a better way to gain exposure to China s faster-growing new economy. From a diversification standpoint, A-shares have also been less correlated to global equities than H-shares historically and for active investors, the dispersion of its returns is significantly higher than many other global markets, according to UBS research. Offsetting these benefits, perhaps, is the fact that A-shares are typically lower yielding than other global markets. Certain behavioural aspects of the A-shares market, meanwhile, can lead to a much different trading experience than usual for many global investors who are new to the market. Of note, retail participation in China accounted for 85.6% of the total A-shares trading volume in 2016, according to a survey published by Shanghai Stock Exchange last year. This lack of institutional involvement can lead to pricing inefficiencies and has tended to coincide with a general preference for small cap and/or momentum stocks that are more volatile than their larger, blue chip counterparts. While the various facets of China s A-shares market can help diversify an investor s portfolio, this must always go hand-in-hand with a thorough analysis of the individual companies being considered. In this regard, the AGF global equity team s criteria for adding A-shares is no different than it is for all the other investable names in the universe. We expect companies to generate a high cash flow return on investment (CFROI) and want our buy candidates to have at least 15% appreciation potential over the next months. Currently, we have identified several interesting A-shares opportunities, but lofty valuations have prevented us from buying in just yet. When we do, our exposure will likely remain minimal as we wait patiently for more opportunities to unfold over time. High Dispersion of Returns in A-Shares Average Standard Deviation of Constituents Monthly Returns 5 Year Average 12.0% 11.0% 10.0% 9.0% 8.0% 7.0% 6.0% 5.0% 4.0% CSI 300 MSCI China FTSE 350 HSCEI Nikkei 225 Source: Thomson Datastream, UBS. As of May 11, FTSE 100 S&P week Rolling Correlation to Global Equities Shanghai A Shenzhen A MSCI China Source: Thomson Datastream, UBS. As of May 11,

4 Appendix: The alphabet of Chinese equities There are thousands of publicly-traded Chinese companies to invest in these days, but not everyone has equal ability to buy and sell them. While the MSCI s recent inclusion of more than 200 Chinese A-shares to its indices helps provide important new opportunities, access still depends on where you live and whether or not you are an institutional or individual investor. Here s a breakdown of some of the key Chinese stock categorizations to help make better sense of it all. A. A-shares refer to publicly-listed companies based in mainland China that are listed on the Shanghai or Shenzhen stock exchanges and quoted in Chinese yuan or renminbi. They are still mostly only available for trading by Chinese citizens living on the mainland, but select foreign investment in these companies is now permitted through the Qualified Foreign Institutional Investor (QFII) system introduced in MSCI s ongoing plan to include A-shares in its various indices should provide even greater access in coming years. B. B-shares also refer to Chinese mainland companies trading on the Shanghai and Shenzhen exchanges, but unlike local currency-denominated A-shares, they trade in U.S. dollars on the former, and Hong Kong dollars on the latter. B-shares were initially offered to target investment from foreign investors, but investment in them from local Chinese investors is also permitted. H. H-shares represent the shares of Chinese companies that are listed on the Hong Kong Stock Exchange and traded in Hong Kong dollars. They are more open for trading to all foreign investors and tend to be more liquid than A-shares as a result. N. N-shares stands for New York shares and represents Chinese companies listed on the New York Stock Exchange (NYSE), NASDAQ, or the NYSE MKT that mostly lists young companies with smaller market capitalizations. N-shares may or may not be incorporated in China but have their main business operations on the country s mainland. 3

5 Regina Chi, CFA Vice-President and Portfolio Manager AGF Investments Inc. Regina Chi is Vice-President and Portfolio Manager with lead responsibility for AGF Emerging Markets strategies. She has an investment philosophy consistent with AGF s Global Equity Team and looks for quality companies that have long-term sustainable competitive advantages at attractive valuations. Regina is a CFA charterholder. She received her Bachelor of Arts in Economics and Philosophy from Columbia University. Regina has a working knowledge of Korean and Spanish. Regina brings 23 years of international equity experience to this role. She was most recently a partner at DePrince, Race & Zollo Inc. where she was portfolio manager for the Emerging Markets and International Value disciplines. She was also head of portfolio management and research as they related to Emerging Markets, Global, International and International Small Cap strategies. Prior to this role, she held senior investment management roles at Oppenheimer Capital, Federated Investors and Clay Finlay Inc. For more information, contact your AGF relationship manager or visit AGF.com/Institutional. Registered as a Portfolio Manager under AGF Investments Inc. and AGF Investment America Inc. CFA and Chartered Financial Analyst are registered trademarks owned by CFA Institute. Commentaries contained herein are provided as a general source of information based on information available as of July 24, 2018 and should not be considered as personal investment advice or an offer or solicitation to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use of or reliance on the information contained herein. Investors are expected to obtain professional investment advice. AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), Highstreet Asset Management Inc. (Highstreet), AGF Investments America Inc. (AGFA), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA). AGFA is a registered advisor in the U.S. AGFI and Highstreet are registered as portfolio managers across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets. Publication Date: August 7, INST E