Ready or not: here come China A-shares

Transcription

1 Bo Meunier, CFA Equity Portfolio Manager China equity strategies Ready or not: here come China A-shares Key points A-shares provide direct access to the rapidly evolving Chinese economy via a broad, liquid set of investable opportunities. We believe A-shares offer investors the potential for attractive returns and portfolio diversification. For the first time, A-shares are easy to access; the Hong Kong Connect programme allows investment without licensing from Chinese authorities. The A-share market is highly inefficient, potentially offering skilled investors significant scope to add value. In June 218, 5% of the massive China A-share market will be added to the MSCI Emerging Markets and ACWI indexes. If A-shares are fully included in the future, they will represent the single largest component of the MSCI EM Index. Bo Meunier, a veteran China investor who resides in Hong Kong, believes that asset owners need to better understand the A-share market as well as the implications index inclusion may have for their emerging markets (EM) exposure. Q: Why do you believe A-shares represent a compelling investment opportunity? MEUNIER: As of September 217, the more than 3, listed A-share companies had a market value of over US$9 trillion. 1 Apart from the sheer magnitude of the A-share opportunity, what I find most intriguing are the exciting transformations happening in China s economy and financial markets. Figure 1 shows the evolution of the Chinese stock market, where sectors like information technology (IT), consumer goods and health care have become much larger components of the index. Seventeen years ago, for example, the IT sector was less than 5% of the benchmark; now it s 43%. Figure 1 Sector exposure is broadening, reflecting a shift in economic exposure MSCI China sector weights over time (%) Utilities 1 Telecommunication services Real estate 75 Materials Information technology 5 Industrials Health care 1 As at 27 September 217 Total number of primary securities, including suspended stocks listed on the Shanghai and Shenzhen stock exchanges, is included. Sources: Win.D, Bank of America Merrill Lynch 25 12/ 5/2 1/3 3/5 8/6 1/8 6/9 11/1 4/12 9/13 2/15 7/16 12/17 Financials Energy Consumer staples Consumer discretionary Data from 31 December 2 to 31 December 217 Sources: MSCI, FactSet

2 2 Wellington Management Today we find opportunities in consumer goods, IT and health care all well represented in the A-share market particularly attractive. As recently as two decades ago, most Chinese consumers lacked basic domestic appliances like refrigerators. This has been changing steadily, and given China s robust economic growth, we believe there is significant scope for further household demand. Consumer sectors typically have few new entrants, so incumbents could potentially achieve attractive returns on invested capital. We believe China s tech and health care sectors are intriguing because of their exploding innovation and increasing penetration in local and international markets. Another change making the A-share market more attractive is the waning presence of state-owned enterprises (SOEs). While China s government is still Communist, its financial markets have rapidly adopted capitalist norms. When I was growing up in China, the government owned and controlled everything. But as Figure 2 shows, the majority of the A-share market capitalisation today is non-state owned. This shift, which we also expect to continue, is a key driver of growth and value creation in China. While SOEs focus on broad national or economic objectives, the primary goal of private-sector companies is value creation for business owners. We have seen more privately held, well-run companies launching in China, and even some state-owned enterprises are undergoing meaningful reforms. Figure 2 Equity market transitioning from state-owned to private Composition of SOE and non-soe companies in MSCI China (%) 1 Non-SOE SOE Sep E Actual data is shown through 3 September 217. Data for 22 is Morgan Stanley Research estimates. Actual data may vary, perhaps significantly, from the estimated data shown. Based on index weights in MSCI China. Sources: MSCI, Morgan Stanley Research

3 3 Wellington Management Q: What are some of the potential benefits of A-share exposure for investors? MEUNIER: We believe that early entrants to the A-share market may see significant appreciation, stemming from a number of trends, including surging innovation and research and development (only the US spends more on R&D), improving corporate governance, low historical correlation with global equities and growing long-term capital inflows. Several cyclical tailwinds appear to be in place for the equity market. We believe valuations are supportive and recent macroeconomic concerns are overstated. Finally, the government is focused more on high-quality, stable growth than on achieving the fastest growth possible. There is a misperception among some foreign investors that A-shares lack liquidity, but that is simply not the case. We believe A-shares also provide a diversification benefit for global investors. Historically, the A-share market has had a very low correlation with equity markets: from its launch in 23 through September 217, the MSCI China A Index has had a correlation of.36 with the MSCI World. That compares favourably with correlations of.84 for the MSCI Frontier Markets Index and.81 for the MSCI Emerging Markets Index. 2 While A-shares correlation will probably rise over time as the Chinese authorities continue their programme of liberalisation, we believe this trend is likely to take quite some time to play out. Q: What other A-share market characteristics do you like? MEUNIER: As active investors focused on value creation through bottom-up stock selection, we are naturally drawn to markets with liquidity, breadth and inefficiency. China satisfies all of those criteria. There is a misperception among some foreign investors that A-shares lack liquidity, but that is simply not the case. The average daily trading volume of China s equity market is over US$8 billion. 3 China trails only the US in market liquidity, and the daily trading volume in the world s third mostliquid market, Japan, totals about one-third of China s. 4 As for breadth, with more than 3, listed companies, China offers a significant range and investment choice. Finally, we are drawn to this market s extreme inefficiency, which provides significant scope for us to potentially add value for our clients. The Chinese equity market is dominated by retail participants who commonly trade on near-term price action. Approximately 85% of the daily volume in the A-share market is driven by retail investors, compared to 37% and 44% of trades in the US and Hong Kong, respectively. 5 As a result of this structural inefficiency, prices may diverge from fundamentals over the shorter term, creating opportunities for longer-term investors to capitalise on these dislocations. 2 PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. As at 3 September 217 Sources: MSCI, Wellington Management 3 As at 3 September 217 Source: Bank of America Merrill Lynch 4 As at 3 December 216 Source: The World Bank 5 US data from 215; China and Hong Kong data from 216 Source: Bank of America Merrill Lynch

4 4 Wellington Management Q: How do you think about A-share valuations? MEUNIER: Despite the recent rally in global equity markets, we believe China still trades at reasonable valuations (Figure 3). A-share valuations vary significantly by market cap, however. As Figure 4 shows, the tech- and growth-heavy ChiNext Index popular with Chinese retail investors trades at a premium to both mid caps (CSI 5) and larger caps (CSI 3), while large-cap A-shares trade at similar levels as internationally listed Chinese companies (MSCI China). It is among larger caps that we find the most attractive opportunities today. Figure 3 China is attractively valued relative to other markets Cyclically adjusted price-to-earnings (P/E) ratios 6 USA World EM China /5 8/6 8/7 8/8 8/9 8/1 8/11 8/12 8/13 8/14 8/15 8/16 8/17 As at December 217 Trailing 1-year cyclically adjusted P/E ratios Sources: CLSA, MSCI, Wellington Management Figure 4 Valuations vary by market cap CSI 3 CSI 5 ChiNext MSCI China /14 5/14 9/14 1/15 5/15 8/15 12/15 4/16 8/16 12/16 3/17 7/17 11/17 As at 24 November 217 Please refer to the end of the document for index definitions. PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS AND AN INVESTMENT CAN LOSE VALUE. Sources: Bloomberg, Bank of America Merrill Lynch; negative readings have been removed.

5 5 Wellington Management In a market heavily influenced by the short-termism of retail investors, we see patience as a virtue. Q: What are some of the risks of investing in China A-shares? MEUNIER: The risks are similar to investment risks posed by other emerging markets, including market- and company-specific volatility, currency movements, political and macroeconomic risks and regulatory risks. For example, investors felt the effect of regulatory risks in 215 and again in early 216 as the Chinese government intervened in the A-share market in an effort to temper rapid security-price increases. In this case, we believe officials have learned from this experience and that, in general, the regulatory environment in China continues to stabilise. Q: How can investors access the A-share market? MEUNIER: With the launch of the Hong Kong-Shanghai Connect programme in 214 and Hong Kong-Shenzhen Connect in 216, the A-share market is now accessible to global investors, without the need for prior regulatory approval and with no capital lockups. This is a monumental shift. Historically, the process of obtaining an investment licence from Chinese authorities was lengthy and expensive, and, in many cases, the licences came with restrictive lockup commitments. Easier, cheaper access should attract many more international investors to this broad market. Encompassing approximately 1,9 large- and mid-cap A-share companies, the Connect programme in our view provides access to the vast majority of investable opportunities in the domestic Chinese equity market. Today, A-shares remain significantly underrepresented in global equity indexes and non-chinese investors portfolios. Just 2% of A-shares aggregate market capitalisation is held by foreign investors, leaving substantial scope for further internationalisation of Chinese capital markets. 6 Q: How does your approach try to exploit the market s characteristics? MEUNIER: We look for companies with good corporate governance and management quality as well as above-average growth prospects, and then assess our analysis and findings with a long-term mind-set. In a market heavily influenced by the short-termism of retail investors, we see patience as a virtue. We believe it is easier to forecast the direction of a company over several years than to predict the timing of a particular transformative event in the near term. This approach naturally leads to lower turnover, reducing the performance drag from transaction fees and implementation costs. Our China investment approach is research intensive and fundamentally driven, supported by our team of emerging market and China analysts as well as our global industry analysts. We check the quality of each candidate company s management team, which we believe is vital to the stock s long-term success. We aim to meet management teams multiple times, along with their competitors and suppliers, before making an investment decision. The skill and experience of the team, and their focus on and track record of dealing with stakeholders and shareholders in their business, are key criteria for us. 6 Win.D; Bank of America Merrill Lynch Companies that meet our standards of managerial quality are then assessed on the strength and sustainability of their business model, and their ability to generate attractive and sustainable long-term returns on capital for investors. We emphasise organic growth, which has the potential to generate sustainable returns on capital, as opposed to growth via mergers and acquisitions or companies that seek growth at any cost.

6 6 Wellington Management About the author Bo Meunier, CFA Equity Portfolio Manager China equity strategies Bo is focused on China and has been based in our Hong Kong office since 211. She also serves as an equity research analyst in Global Equity Portfolio Management, specialising in emerging markets with primary responsibility for China broadly. A native of China, Bo travels extensively throughout the country, conducting fundamental analysis of Chinese companies for the portfolios under her management as well as making buy/ sell recommendations to portfolio managers based on her findings and on market conditions. Finally, we create a valuation model for each company to determine our long-term price target for the stock. Only companies trading at attractive valuations versus our assessment of their longer-term price potential will be considered as investment opportunities for the portfolio. Through this research process, we seek a low-turnover, total-return-focused, concentrated portfolio of 2 3 stocks typically, with the potential to compound capital over three to five years. Q: What do you think gives you an advantage as a manager? MEUNIER: I believe that the combination of deep local knowledge, local language skills and international training gives me a differentiated perspective. I grew up in China, in Shenyang, a city in northeastern China just 15 miles from the border with North Korea. Shenyang has a population of five million, larger than any city in the US except New York. I completed my studies in China before moving to the US to earn my MBA. I then worked for several years at a large corporate consultant as a businessvaluation analyst, before joining Wellington Management. Since 25, I have been a member of the Emerging Market Equity Team, focusing on China equity research. As an internationally trained institutional investor, I bring to the analysis and exploration of investment opportunities in China an approach and mind-set that is not shared by many locals. At the same time, my native language is Mandarin, which helps me to interact directly with the management teams of Chinese companies. I have been based in the firm s Hong Kong office since 211, which brings me closer to the region and the Chinese companies under my coverage. I believe that my long-term investment horizon, my focus on quality and strong governance standards and my fundamentally driven analytical approach are important differentiators from many of my competitors. In addition, Wellington Management s robust investment research capabilities, including the direct analysis of A-share companies conducted by our team of 56 global industry analysts, give me global insights into China that local firms and smaller boutiques may not have. INDEX DEFINITIONS CSI 3 Index: the CSI 3 Index replicates the performance of the 3 stocks with the largest capitalisation traded in the Shanghai or Shenzhen stock exchanges. CSI 5 Index: the CSI 5 Index replicates the performance of 5 mid- and small-capitalisation stocks traded in the Shanghai or Shenzhen stock exchanges. The index excludes stocks included in the CSI 3 Index or which rank in the top 3 stocks in the Shanghai or Shenzhen stock exchanges. ChiNext Price Index: ChiNext is a NASDAQ-style board of the Shenzhen Stock Exchange. ChiNext aims to attract innovative and fast-growing enterprises, especially high-tech firms. The MSCI China Index captures large- and mid-cap representation across China H-shares, B-shares, red chips and P chips. It contains internationally listed Chinese companies only and does not include domestic A-shares.

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