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Why the China's A-share market is more investable than you think

17 October 2017

Raymond Deng, senior research analyst at Matthews Asia, and portfolio manager Joyce Li explain the challenges and opportunities for investors of investing in Chinese A-shares.

China’s domestic A‐share stock market grabbed global headlines in 2015 with its roller‐coaster performance and frequent government intervention.

More than two years later, such impressions still linger but China’s A‐share market has grown too large for investors to ignore.

With $8.5trn in market capitalisation and more than 3,400 listed companies, China’s A‐share market is the second‐largest stock market in the world, behind only the US market.

In recognition of this, index provider MSCI recently decided to allow 222 of China’s large‐capitalisation domestic A-share stocks to be gradually included into its Emerging Market Index, starting in mid‐2018.

The inclusion of the A‐share market is set to alter portfolio allocation strategies.

During conversations with investors, we have often found that their hesitation to invest in A‐share companies stemmed from a perception of poor corporate governance.

Is the A‐share market really a jungle too difficult for investors to navigate? We would argue that it isn’t; however, investing in A-shares has its pitfalls.

State‐owned enterprises (SOEs), for example, accounted for over 60 per cent of the CSI 300 Index weight and about 80 per cent of total revenue in 2016.

SOEs historically have been poor capital allocators and SOE managers have been prone to putting government directives ahead of shareholder interests.

This means a passive approach to investing in A‐shares could lead to excessive exposure to SOEs in portfolios.

Also, investor concerns remain about the possibility of poor disclosure and accounting standards among companies in the A‐share market.

Furthermore, retail investors tend to dominate the trading in the market, often leading to higher levels of volatility.

 

Seeing investment opportunities

Nevertheless, we believe China’s domestic A‐share market provides attractive investment opportunities.

It is important to recognise that the breadth and depth in the A‐share market are much greater than those offered by offshore Chinese equities.

Over 200 health care companies with a market‐cap value of $100m or more are listed in the A‐share market, for instance, while only about 80 companies are listed in offshore markets.



Also, leading producers of Chinese distilled liquor—a market with sales of $115bn in 2015—are listed only in the A‐share market.

Overall, the A‐share market opens more opportunities for global investors to take part in China’s dynamic economy that is taking shape as the country shifts away from exports and manufacturing and more toward innovation, consumer consumption and services.

Non‐domestic access to A‐share stocks also has been improving. China’s regulators further opened the country’s capital markets by creating “Stock Connect,” a trading link that connects the Shanghai and Shenzhen stock exchanges to the Hong Kong Stock Exchange, enabling foreign investors to buy A‐shares with fewer restrictions.

Performance of indices over 3yrs

 
Source: FE Analytics

 

Disclosures point to better governance

A‐share companies are outdoing Chinese companies listed in offshore markets in areas such as comprehensive disclosure requirements and stricter regulation on potential conflicts of interest.

In addition, executive compensation and company ownership changes are required to be disclosed regularly for China A‐share companies but not for those listed in Hong Kong.

Compared to other Asian markets, the post‐vetting of company announcements by stock exchanges is more comprehensive among A‐shares.

Disclosures by A‐share companies are regulated by both the Chinese Security Regulatory Committee and the Shanghai and Shenzhen stock exchanges.

The multi‐layer regulatory regime means additional scrutiny.

 

Creating value for investors

We consider companies that generate returns for investors that exceed their cost of capital as “value creators”.

Our research indicates that only about 30 per cent of A‐share non‐financial companies were value creators over the past five years. A 30 per cent figure might sound low, but let’s put that number into context.

The A‐share market provides much greater depth and width with more than 3,000 non-financial companies that have a market value above $100m, more than double the number of Chinese companies listed offshore.

Around 30 per cent of this universe translates into 971 non‐financial companies that create economic value, more than the total number of value creators in Taiwan and South Korea combined in our analysis of 10,044 non‐financial companies in the region.


 

Focusing on capital allocation discipline

During China’s fast‐growing decades, Chinese corporations focused on allocating capital to create growth in many industries, resulting in overcapacity in some cases and erosion of shareholder returns.

In recent years, we have observed an encouraging improvement in Chinese leadership’s attitude toward capital allocation. It is no longer about more capital, but about ensuring that capital goes to the right places.

The government encourages banks to lend to private enterprises, offers companies incentives to pay out higher dividends and incorporates environmental metrics when evaluating the performance of government officials.

Such top‐down governance changes are reflected in better capital allocation by listed companies.

One measure of capital allocation discipline is capital expenditure in excess of depreciation. A rising surplus usually means accelerating capacity expansion, while a falling surplus usually means moderating capacity growth.

Our recent analysis of 495 A‐share companies in the materials sector indicated that state-owned companies and non‐state‐owned companies both have cut back on the speed of their expansion since 2012.

The materials sector is not an anomaly. We observed similar results in some consumer staples businesses where excessive supply exists.

A few A‐share listed breweries have begun closing down some small production facilities and cutting idle capacity in order to improve operating efficiency. As a result, the value of their fixed assets—property, plant and equipment—declined for three straight years.

Among state‐controlled companies, we are seeing instances where companies dispose of noncore assets to focus on their core businesses.

GDP quarter-on-quarter growth 2010-2017

 

Source: OECD

 

Scrutinising A‐shares from the bottom up

Understanding the nuances of the state’s ownership in A‐shares and individual companies is a critical  aspect of our research process.

SOEs clearly play an important role in the Chinese economy, but not all SOEs are created equal when it comes to corporate governance.

The Chinese government requires that SOEs comply with different evaluation criteria depending on the types of businesses.


Only the SOEs in a fully competitive industry are evaluated based on economic value creation and return on assets.

For the SOEs in the industries critical to national security and social welfare, serving the national interest and public service are the top priorities. The weight placed on economic value creation and profitability in evaluating such companies is lower.

State ownership varies by sector in the A‐share market. By sector, we find high SOE revenue representation in energy, materials, telecommunications, utilities and industrials and low representation in technology, consumer and health care. SOEs, for example, accounted for only 36 per cent of companies and 34 per cent of revenues among A‐share‐listed consumer staples companies in 2016.

As the Chinese economy becomes more service‐oriented, these sectors provide many potential investment opportunities.

It is important to note that active investment strategies have the advantage of selecting investments among a higher percentage of non‐SOE companies. SOEs, due to their large sizes, have a much higher representation in the CSI 300 Index.

SOEs accounted for 80 per cent of revenues from the index constituents in 2016. In addition, the revenue share from SOEs has declined over time for most sectors in the A‐share market.

SOEs in the healthcare sector, for instance, contributed 46 per cent of the sector’s total revenue in 2016, down from 64 per cent in 2006.

Similar trends in a number of sectors reflect the market‐share gains of companies without state ownership and China’s shift to its consumption and service‐oriented economy.

Raymond Deng is senior research analyst, while Joyce Li is portfolio manager at Matthews Asia. The views expressed above are their own and should not be taken as investment advice.

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