Large, liquid and unloved: China’s story runs deeper than trade

Jeff Shen |Oct 2, 2019

China’s onshore equity market, while both vast and liquid, is relatively untapped by foreign investors. Jeff Shen looks beyond the trade war to explore the makings of a unique investment opportunity.

Most of what investors hear about China today centers on the trade conflict and technology competition with the U.S. These issues, and the headlines they generate, are unlikely to disappear anytime soon. Yet they mask some important and less-read “footnotes” about the world’s second-largest economy ― and the burgeoning opportunity in its onshore A-Share equity market.

We find China A to be rich in opportunity for a few key reasons:

1. Information abundance

China is a particular interest to systematic investors, like myself, who use data as the lifeblood for uncovering unique investment insights. In fact, we find few places as ripe for tapping new and innovative sources of information.

This is due not only to the sheer size of China’s population, but also its rapid adoption of digital technologies and willingness to share personal information. A 2018 survey by market research institute GfK found that 38% of China’s internet users said they would share personal data online. This compared to a global average of 27% and was well ahead of major developed markets such as Japan (8%), Germany (12%), the UK (16%) and the U.S. (25%).

Finding an information advantage and acting on it ahead of other investors is a key way to gain a performance edge. This has always been the case in investing, but is even more important in today’s data-intensive world where finding unique kernels of unexploited, investment-relevant info is increasingly difficult.

2. Large opportunity, lite interest

Many investors do not realize China A represents the second-largest and most liquid market in the world, just behind the U.S.

The process to include China A-Shares in major global equity indexes began last year and has provided greater international visibility for Chinese stocks. MSCI will have increased its inclusion factor of large-cap China A-Shares in its emerging markets index from 5% earlier this year to 20% by November. Yet the share of foreign investors in China A remains below 5%.

The fact that the market is not as intensively researched also suggests that active investing ideas can be more powerful and persistent than in markets where information is quickly and broadly absorbed and invested on.

The current state of play may present an interesting entry point: A-Share integration will continue for a few years. When it is done, China’s onshore (A-Share) and offshore (H-Share) markets will essentially have converged. (China H-Shares trade on the Hong Kong Stock Exchange and are already open to all investors.) This may mean there is a window of opportunity for investors to tap into A-Shares before any distinction between the two markets disappears.

3. Reforming toward a new norm

Some argue that Chinese equities failed to deliver in recent years, when the domestic economy was growing exponentially. This was the case even as corporate earnings expanded. So, they question, what may be the impetus now?

Going forward, we see the Chinese equity market benefiting as the country’s economic growth model transitions away from investment and exports in favor of domestic consumption and services. Chinese companies historically have exhausted their free cash flow to support the investment-led growth model, leaving little to distribute to shareholders. This is already starting to change, as we see evidence of a material increase in dividend payments.

We also see reform continuing, but with a broader, modernized focus. Through our text mining and data analysis work, we see indications of Chinese authorities’ increased attention on citizen-friendly tax cuts and investor priorities such as technology and environmental protection. See the chart below. Lower taxes can free up more money to support domestic consumption and overall economic growth.

See Jeff’s Q&A on ESG.

Bottom line

Given the size and uniqueness of the Chinese equity market, we believe it is on its way to parting from emerging markets broadly and eventually becoming an asset class on its own. The current dynamics, discussed above, suggest to us that this may be a timely moment to consider exposure to the burgeoning opportunity in China A.


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