China A-shares: A differentiated and compelling opportunity

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1 Solutions April 2015 China A-shares: A differentiated and compelling opportunity Q: Why do you believe A-shares represent a compelling investment opportunity? MEUNIER: Over the past two decades, China has engineered a rapid yet carefully calibrated transformation of the country s economy. From 1993 to 2013, China s share of global GDP increased six-fold, from less than 2% to over 12%. Bo Meunier, CFA Equity Portfolio Manager Bo is a portfolio manager and equity research analyst focusing on China. Based in our Hong Kong office, she is a long-standing investor in China A-shares as a component of her China equity portfolios as well as the firm s broader Emerging Market portfolios. In addition, Bo is the portfolio manager for our new, dedicated A-share portfolio in China, a market she believes will become an increasingly important and strategic constituent of global equity allocations. The regulators have had a similarly long-term plan to open up Chinese financial markets to overseas investment, and they started liberalizing the A-share market back in The Shanghai-Hong Kong Stock Connect, which for the first time offers non-chinese investors unlicensed access to shares listed on the Shanghai Stock Exchange, is an important milestone on the road to full liberalization (see our September 2014 Postcard Chinese A-shares: Through train to deliver the goods ). Building on this momentum, a program allowing foreign investors to access companies listed on the Shenzhen Stock Exchange is expected to launch in the second half of Nevertheless, market liberalization has significantly lagged the development of the economy, largely because of concerns about the potential disruption from uncontrolled capital inflows. As a result, A-shares remain significantly underrepresented in global equity indexes and, importantly, in non-chinese investors portfolios. In addition to the potential for significant appreciation stemming from economic growth, we believe that early entrants to the A-shares market stand to benefit from several structural factors, such as improving corporate governance, a low historical correlation with global equities and long-term capital inflows, as well as a number of cyclical tailwinds, including supportive valuations and overstated macroeconomic concerns. The views expressed are those of the authors, are as of the date indicated and are subject to change without notice. Different portfolio management teams at may have different views. Material is not to be construed as investment advice or a recommendation to buy or sell any security. Where noted, data provided is that of a third party. While data is believed to be reliable, no assurance is being provided as to its accuracy or completeness. Key points The process of liberalizing the China A-share market has begun, allowing foreign investors to access locally listed Chinese stocks. A-shares provide pure access to the rapidly evolving and growing Chinese economy, and the set of investable opportunities in the A-share market is both wider and more liquid than that available in the internationally listed China equity market. We believe A-shares offer non-chinese investors the potential for attractive returns and good diversification within global portfolios. The market s characteristics and inefficiencies create opportunities for longterm investors with a focus on companies organic growth prospects and management quality.

2 2 Q: What does the A-share market offer that investors cannot already get via Chinese stocks listed in Hong Kong and elsewhere? MEUNIER: The A-share market offers a broader, more diversified set of investment opportunities than is available via offshore-listed Chinese companies, as Figures 1 and 2 show. Compared with offshore-listed Chinese stocks, the A-share market has lower weightings in the telecoms, energy, IT, and financials sectors and higher exposures to consumerrelated stocks, health care, industrials, and materials (Figure 1). With these weightings, the A-share market is more representative of the Chinese economy than is the MSCI China. Figure 1 A-shares offer greater sector diversification than the MSCI China Index MSCI China A MSCI China* % Telecommunication services Energy Information Financials Utilities Consumer Health care Consumer technology staples discretionary Materials Industrials *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. Source: MSCI, as of 28 Feb 2015 While not yet as broad as the US market with its 4,300 listed companies, the China A-share market nevertheless offers investors over 2,500 companies listed on the publicly traded markets of mainland China, more than 500 of which have market capitalizations of US$2 billion or more. The A-share market is particularly abundant in the smaller-cap range of US$500 million to US$2 billion (Figure 2). Over 1,500 such companies are available to investors, compared with roughly 1,100 US-listed companies of a similar size. And relative to Hong Kong the proxy market for Chinese exposure for most global and international investors the A-share market provides a much wider range of investable opportunities. It has 2,000 stocks with market capitalization above US$500 million, compared with 564 listed in Hong Kong.

3 3 Figure 2 A-shares provide a wider range of market capitalization than H-shares 4,500 4,000 US China A-shares China H-shares 3,500 3,000 Number of stocks 2,500 2,000 1,500 1, < >10 Total Market capitalization, in US$ billions February 2015 Source: Bank of America Merrill Lynch Many foreign investors assume the A-share market lacks liquidity. In fact, it is highly liquid relative to Hong Kong and even, on some metrics, the US market (Figure 3). Figure 3 The A-share market is relatively liquid 1,600 US China A-shares China H-shares 1,400 1,200 1,000 Number of stocks < > day average daily trading volume, US$ millions February 2015 Source: Bank of America Merrill Lynch Roughly 2,200 stocks in China (more than 85% of the total market) have average daily trading volumes of US$5 million or more. That compares with approximately 1,700 stocks in the US (some 40% of the market) and around 180 stocks listed in Hong Kong (only 10% of the market). As an investment firm focused on value creation through bottom-up stock selection, we are naturally drawn to markets that offer both a wide range of opportunities and deep liquidity. The A-share market satisfies both of these criteria.

4 4 Figure 4 Retail investors dominate daily trading volumes on the A-share market Retail investor participation as a percentage of average daily trading volume % In addition to breadth and liquidity, we are also drawn to inefficient markets: the greater the level of inefficiency, the greater the scope for skilled investors to add value. The A-share market is dominated by retail participants, who typically trade on near-term price action, rather than fundamentals (Figure 4). As a result, prices may diverge from fundamentals over the shorter term, creating opportunities for longer-term, fundamental investors to take advantage of these mispricings. We expect Chinese regulators will continue opening up the market to foreign investors and that large capital inflows will follow. Currently, A-shares are not represented in the MSCI Emerging Markets Index. According to MSCI s calculations as of 2014, if A-shares were fully included, they would account for over 15% of the index, nearly twice as much as the whole Brazilian market. MSCI said that most investors it surveyed in 2014 were resistant to A-shares inclusion in the index, because market access is restricted and uneven. However, we believe that their reluctance will fade with further liberalization and that MSCI will start including A-shares in its indexes over the next few years China A-shares Hong Kong US 2014 data Source: Bank of America Merrill Lynch Q: Given the difficulty of access for non-chinese investors, do A-shares offer diversification opportunities? MEUNIER: Throughout its history, the A-share market has had a very low correlation with other equity markets globally (Figure 5). From its launch in 2003 to the end of February 2015, the MSCI China A Index had a historical correlation of only 0.28 with developed equity markets (the MSCI World Index). That compares favorably with correlations of 0.66 for the MSCI FM Frontier Markets Index and 0.76 for the MSCI Emerging Markets Index. From a diversification standpoint, few markets currently offer lower historical correlations with global equity market returns. While A-shares correlation will probably increase over time as the Chinese authorities continue their program of liberalization, we believe this trend is likely to play out over a number of years, rather than months. In the meantime, we think that exposure to the A-share market affords an opportunity for significantly enhancing the diversification of equity allocations. Figure 5 A-shares low correlation with global equities indicates diversification From 30 May 2003 to 28 Feb 2015 MSCI The World Index Rolling 12 months % MSCI China A MSCI Emerging Markets MSCI FM Frontier Markets S&P 500 Rolling 12 Rolling 12 Rolling 12 Equity index correlations months % months % months % MSCI The World Index 1.00 MSCI China A MSCI Emerging Markets MSCI FM Frontier Markets S&P Rolling 12 months % Sources: MSCI,

5 5 Q: A number of corruption, insider-trading, and corporate-governance scandals have tainted the market s reputation in recent years. Are these concerns a thing of the past? MEUNIER: These risks remain, but we believe they are waning. Regulators have been working hard to improve corporate governance standards, and President Xi Jinping is leading a vigorous anticorruption drive. While some of the A-shares newly available to overseas investors still have corporategovernance issues, we believe the universe includes many stocks with strong management teams, solid balance sheets and attractive returns on capital. It is our view that lingering concerns about these problems have created valuation opportunities in many areas, making the market well suited to fundamental, active stock pickers. Importantly, our China A-share investment approach and philosophy, which seeks to identify quality companies with strong management teams focused on creating returns for shareholders, aims not only to mitigate governance risks in the companies in which we invest but also to capitalize on these market inefficiencies. Q: A-shares have enjoyed a strong rally in recent months. Are valuations now prohibitively high? MEUNIER: We believe that valuations are still supportive (Figure 6). The A-share market has risen since mid-2014 as local investors have switched their focus from the declining property market into listed equities. However, the market had previously suffered from several years of underperformance which had taken valuations to a significant discount to other stock markets. Based on consensus forward price-to-earnings ratio (P/E), we believe the market remains attractively valued versus US and global equities, with exciting opportunities in specific stocks and in the particular areas that are the stated focus of our investment philosophy. Figure 6 A-shares valuation still looks reasonable versus global equities Comparison of 12-month forward P/Es 18 MSCI AC World MSCI China A MSCI US /11 8/11 2/12 8/12 2/13 8/13 2/14 8/14 2/15 Sources: Datastream, MSCI, FactSet, CLSA

6 6 We see other cyclical grounds for favoring the A-share market. First, investors expectations for the market appear muted amid concerns about the structural decline in Chinese GDP growth. In our view, these concerns are overstated. At this stage of its development, China could not reasonably be expected to sustain the previous rate of expansion, having consistently delivered GDP growth in the range of 8% to 12% a year for much of the last two decades. Furthermore, at a target rate of 6.8% for 2015, growth would be high relative to the rest of the world. We expect investor expectations for China to rerate as near-term concerns of a hard landing fade. Second, the crackdown on corruption has had a direct impact on many sectors, notably luxury goods. However, this slowdown should prove temporary, and we believe that growing demand from the increasingly affluent middle class will more than offset the reduction in spending caused by the crackdown on the high end of the market. Upgrading demand from lowerend consumers could also be a key driving force in the consumer-goods sectors in China for many years to come. Q: You mentioned the Stock Connect scheme earlier. What other ways are there to enter the A-share market? MEUNIER: Investors now have four potential means of access. The Qualified Foreign Institutional Investor (QFII) scheme, launched in 2002, offers foreign institutions access to Chinese capital markets in a very controlled manner. The total quota for the program is US$150 billion, US$90 billion of which has already been approved to over 130 institutions worldwide. As QFII was China s first step towards market liberalization, the scheme came with many restrictions on quota applications, asset allocation, cash flows, and so on. For example, there are lockup periods of three months for open-ended funds and 12 months for separate accounts. Repatriation of principal and profits after the lockup is also subject to various restrictions. The Renminbi Qualified Foreign Institutional Investor (RQFII) scheme was launched in 2011 to allow institutional investors in specified locations, such as Hong Kong, London, and Singapore, to use their offshore renminbi to purchase securities. The total quota for the scheme is currently RMB640 billion (US$103 billion), with RMB330 billion already approved to over 110 institutions. While many of the same restrictions apply, it is a much more flexible program than QFII. For example, the restrictions on asset allocation have been removed, and many of those on quotas and cash flows have been relaxed. There is no lockup for open-ended funds (though the 12-month period still applies to separate accounts), and they can have daily liquidity. Our London-based office, International Ltd, currently holds an RQFII licence. The Stock Connect program was launched in November 2014 to liberalize the market further. It allows foreign investors direct, unlicensed access for the first time to select securities (currently 569 companies) listed on the Shanghai Stock Exchange. The aggregate quota for the program is RMB300 billion, with a daily quota of RMB13 billion. Stock Connect does not have any restrictions on flows, other than the market quota. A similar program to include Shenzhenlisted securities (known as Shenzhen-Hong Kong Stock Connect) is expected to launch later in The Shenzhen Stock Exchange is home to many of China s new economy companies in the technology, pharmaceuticals, and clean energy industries. The proposed program will expand and complement the opportunity set of heavy industry and financial stocks that dominate the Shanghai Stock Exchange. Given its potential expansion and the accessibility Stock Connect provides, plans to use it as part of our China A-share platform.

7 7 China A-share Access Products include warrants, participatory notes (P-notes), swaps, and other derivatives for obtaining synthetic access to the A-share market. While these are obviously not subject to the same restrictions as the QFII and RQFII schemes, they expose the holder to counterparty risk, as well as dealers documentation and terms to which some investors may object. Transaction costs would be higher than for the other programs. As with any emerging equity market, there are risks associated with A-share investment. These include the volatility of the market itself, stock-specific and governance risks, macroeconomic and political risk, currency risk, and liquidity risk. While investors in the A-share market need to be mindful of these risks and take them into account when deciding both how much of their portfolio to allocate to the A-share market and the means of implementing that allocation, we believe that the investment opportunities available in the A-share market are meaningful and attractive and have the potential to offer investors compelling risk-adjusted returns over time. Q: What are the distinctive characteristics of the A-share market? MEUNIER: One of the most interesting characteristics is that, while institutional investors own the vast majority of the capitalization, retail traders are largely responsible for the market s volatility. Local institutions, including the government, own 74% of the mainland China equity market by capitalization (Figure 7), more than in either the US or Hong Kong. However, these institutions tend to be very long-term, buy-and-hold investors, and local retail investors dominate the trading volume in the market. Figure 7 Institutional investors dominate ownership of equity market Ownership of outstanding equity market capitalization Institutional Retail % US China HK UK and HK data as at December 2014; China data as at December 2013 Source: Bank of America Merrill Lynch Retail investors in the A-share market typically have short holding horizons, while many are also momentum-driven and will pay high valuation multiples in rising areas of the market. This combination of factors can lead

8 8 to high levels of market volatility. In addition, local retail investors tend to have a bias towards firms with aggressive growth profiles, rather than concentrating on return on equity. Q: How does your approach try to exploit these characteristics? MEUNIER: We look for companies with good corporate governance and management quality as well as above-average growth prospects, and we 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 travel 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 impact costs. Our dedicated China A-share 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. Given concerns about the history of poor corporate governance in China, 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 company management teams multiple times, along with their competitors and suppliers, before making an investment decision. The skill and experience of the management team, and their focus on and track record of dealing with stakeholders and shareholders in their business, are key criteria for the approach. 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. 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 stocks, with the potential to compound capital over three to five years. Q: Where do you see particular opportunities in the A-share market at the moment? MEUNIER: We believe there are opportunities at present in old economy sectors such as consumer durables, real estate companies, and industrials which are well represented in the A-share market. As recently as two decades ago, most Chinese consumers lacked basic domestic appliances, such as refrigerators. With the subsequent rapid growth of the economy, many investors have recently focused on more high-tech sectors, but we believe there is significant scope for further penetration in the consumergoods market as new households enter the market and existing owners upgrade their old appliances. Another advantage of investing in these old-economy sectors is that there are typically few new entrants, so the incumbents can potentially achieve attractive returns on invested capital. We think there are similar opportunities in select auto manufacturers, with both first-time buyers and upgrading demand supporting the sector.

9 9 Q: What do you think gives you an edge as a manager? MEUNIER: I believe that the combination of deep local knowledge and international training gives me a differentiated perspective. I grew up in Shenyang, a city in northeastern China just 150 miles from the border with North Korea. Shenyang has a population of 5 million, larger than any city in the US except New York. While few people outside China have heard of it, Shenyang is known across China for its well-preserved Forbidden City, which is similar to Beijing s, its strong soccer team, and its tasty dumplings. Shenyang was focused on machinery and heavy industry. As a child, I wanted to follow my dad and become an engineer. In my 20-plus years growing up in China, I remember people buying their first sewing machines, TVs, washing machines and refrigerators. I saw that household devices made people s lives easier, so my ambition was to build them. At that time, though, few people could have envisaged that China would now be the largest new-car market in the world. After graduating from college in China, I earned my MBA in the US. I then worked for several years at a large corporate consultant as a business-valuation analyst, before joining as an analyst covering US and Asian property stocks. Since 2005, 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 2011, 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, 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.

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