China-A Share Research
Just as investors prepared for China A-shares’ entry into the MSCI Index in August, the tit-for-tat on tariffs between the world’s two biggest nations caused global stock markets to retreat. “We still don’t know how big this will get yet,” says Jack Lee, Schroders’ Shanghai-based head of China A-share research, adding that it was quite easy for China to absorb the initial tariff package of $50 billion on Chinese goods because it is equivalent to just 2% of China’s total global exports in 2017.
Tariffs on the first batch of $34 billion worth of Chinese imports kicked in early July. While there are ways for China to circumvent the impact, i.e. seeking trade pacts with other nations and setting up plants in the US, Lee says the short-term situation is still unstable.
Given this medium-term uncertainty, Lee indicates that investors need to analyse the stock market from a ‘bottom-up’ approach. “The question to ask is, what is a company’s exposure to the US?” says Lee, who believes the same principles used to identify investment opportunities in a normal business environment still apply. He says Schroders adopts an unconstrained approach that focuses on understanding a company’s business model, risk and return drivers, management’s track record and corporate governance.
Although equity markets could decline further if tensions escalate, valuations of stocks worldwide, not just China shares, will be marked lower to account for slower global growth. Lee says the Shanghai Composite Index has trended lower since February, and aside from trade tension, the market has also been pressured by a sliding yuan.
THE IMPLICATIONS OF MSCI'S INCLUSION
A weaker A-share market occurred as the market awaited the MSCI two-stage process of including China A-shares into its MSCI Emerging Markets and World Indices benchmarks. The first half of a 5% initial weight occurred on May 31, 2018 with the balance taking place three months later. At full inclusion, the A-share market should represent 0.8% and 0.1% of both benchmarks respectively.
Lee says interest in A-shares picked up following the MSCI’s move to include China A-shares in its indices, and the availability of Stock Connect but trading volume and stock prices have since fallen. Still, Lee believes investors shouldn’t disregard China as a long-term player because the country’s representation in global indices will inevitably increase. At full inclusion, China A-shares will account for 14% of the MSCI AC Asia ex-Japan Index (as of the end of July 2018).
EQUITY MARKET REFORM GAINS PACE
China recently quadrupled daily southbound and northbound quotas for the Hong Kong-Shanghai and Hong Kong-Shenzhen Stock Connect trading links. It also scrapped a 20% capital repatriation limit for foreign investors under its Qualified Foreign Institutional Investor (QFII) programme.
Progress has also been made on other fronts, including the introduction of China Depository Receipts (CDRs), However, no company has yet listed due to recent market turbulence. A CDR is a form of depositary receipt traded on Chinese stock exchanges which is issued by a bank and represents equity in foreign corporations. It permits domestic Chinese companies listed overseas to gain access to China’s domestic investors. In other areas, Lee says China has set up a so-called ‘Green Channel’ to fast-track initial public offerings (IPOs) of strategically important sectors. There are several hundred companies currently on China’s IPO queue, and unlike developed markets, where market fundamentals determine listings, China’s initial share sales must also be approved by state authorities.
One critical impediment to China’s share market development remains its foreign-ownership limits. Foreigner corporates are only allowed to own 30% of a domestic company. “Theoretically speaking, this places limits on the MSCI free-flow inclusion factor because foreign investors can’t buy an entire listed company,” says Lee. While China continues to deregulate its financial markets, the Chinese A-share market shows signs of maturity Lee observes, with its share performance becoming less speculative and more reflective of fundamentals and valuations.
Foreign investors typically apply a much stronger valuation discipline than local players. They stick with things they understand, whereas China’s domestic players may be a bit more speculative in their approach,” adds Lee.
ALL-CHINA MARKET DEPTH IMPROVES
Based on market capitalisation and the number of stocks, A-shares dwarf those listed offshore. Supported by the Stock Connect schemes, global investors can access more than 1,560 out of over 3,000 stocks listed onshore in China. This compares with 225 H-shares and under 300 American Depository Receipts (ADR) traded in US stock exchanges and over-the-counter (OTC) markets.
Hong Kong and
Head of Institutional
Chris Durack, Schroders’ CEO, Hong Kong & Head of Institutional Business, APAC, suggests investors take an ‘All-China’ approach to investment. “When investing in China, you should look at the whole set of opportunities it presents. In the past, you could only buy offshore, but now you can buy both offshore and onshore. In our view, investors are increasingly better able to take advantage of the convergence in China’s shares occurring. The MSCI China All Shares index aims to cover 85% of the free float market capitalisation of integrated China equity markets by combining A, B and H-shares, Red-Chips, P-Chips and foreign-listed shares,” says Durack.
With a suite of products, extensive research capabilities and 22 China experts, Schroders’ Greater China equity team is well positioned to take an ‘All China’ approach to investment opportunities. Underscoring this approach is its belief that the key to realising opportunities and returns is a deep understanding of the fair value of stocks and that good governance is essential when it comes to finding quality companies.
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This document is intended to be for information purposes only and does not constitute any solicitation and offering of investment products. Investment involves risks. This material has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.