The growing universe of smaller companies in China presents investors with an opportunity to tap a hotbed of innovation within a segment that has long been undervalued, according to Tiffany Hsiao, portfolio manager at Matthews Asia.
China in recent years has fostered entrepreneurship and innovation among an ever-growing and prosperous middle class. Add the mainland’s unprecedented scale to the mix, and the foundations for the country’s small businesses to compete with their much larger peers become apparent.
China is second only to the U.S. in terms of its liquidity, breadth and depth of its equity markets and many of the positive structural changes in the economy are well-reflected in its equity markets. Over 4,500 Chinese small companies (those with market capitalisations between $100 million and $3 billion) are listed in China, Hong Kong, the US and other global markets.
As China has transitioned to a services and consumption economy, smaller entrepreneurial companies are developing the goods and services that an increasingly affluent market demands. A way for these smaller companies to win is through sustainable innovation. This could be technological innovation that results in an intellectual-property moat or simply a better way to do business.
China’s entrepreneurs also are used to hardship; they largely have had no access to bank finance for the past 30 years. As a result, China small caps tend to be capital-efficient, with low leverage levels and a high rate of return on capital invested.
“Chinese small companies cannot be wasteful with their capital,” Hsiao said. “Entrepreneurs learned to be more competitive, innovative and capital-efficient to both survive and thrive.”
Share prices for China’s small companies, meanwhile, often are less volatile because of their capital efficiency and low exposure to macroeconomic monetary policies.
OPPORTUNITIES BECOMING APPARENT
If China’s entrepreneurs are the epitome of self-sufficiency, investors in their small-cap companies have to be, too. Hsiao says non-Chinese investors have little choice for pure exposure. Even fund managers need to do their homework to establish the real valuation of the stocks involved.
Analyst coverage of small-cap firms can be low, presenting an opportunity to find higher-growth companies at lower valuations because they are lesser known.
“For now, there are fewer participants in the China small-cap space because the information flow is very inefficient,” Hsiao added, “so the probability of generating alpha is, in our view, much higher.”
As they service the domestic economy, China’s small-cap companies are less affected by geopolitics and global trade sentiment than their large overseas peers. “China is moving away from obsessively building physical assets to obsessively building intellectual property,’” she said.
In particular, Hsiao has high hopes for the Chinese biotech sector. She predicted that China could become the global powerhouse for medicine and treatment innovation within a decade. Supply and demand favor the small-cap innovators.
ATTENTION ALL SECTORS
China’s relatively young and tech-savvy population is a welcome recipient of such progress. Migration trends, policymaking and demographics have combined to create a flexible, mobile workforce that embraces new business models and products.
Meanwhile, efforts driven by regulation and various initiatives to expand renewable sources of energy including wind and solar are spawning new industries such as electric vehicles, along with the batteries to power them.
These examples barely scratch the surface of the potential investments that China’s wave of innovation creates. Further, small-cap opportunities exist in all sectors of the mainland’s market, not just in technology. Hsiao said continuing reforms create prospects for companies focused on all sorts of sectors, ranging from industrial automation to health care to consumer discretionary.
And in areas such as pharmaceuticals discovery or diagnostics, no longer can China be labeled in the West as a “copycat.” Initiatives to foster innovation, for example, have led to research and development programs that would be envied in many countries.
“We believe small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments such as manufacturing, infrastructure and real estate, and toward innovation, consumption and services,” Hsiao explained.
Indeed, she noted that smaller Chinese companies that tap into the entrepreneurial spirit across cities and provinces tend to thrive mostly in productivity- and value-enhancing industries such as automation, health care, e-commerce and education.
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