Understand emerging markets opportunities and the American Century advantage.
China's A-share stocks, whose market capitalization is second only to that of the U.S., will be integrated into the MSCI Emerging Markets Index on June 1. The inclusion of A-shares presents a significant opportunity for non-Chinese investors to tap the return and diversification potential of the growing Chinese market. Investing in China is much different than investing in other emerging markets (EM) countries, so investors should be aware the complexities and risks of investing in this emerging economy. Ten things to keep in mind include the following:
Senior Quantitative Analyst
China's stock market represents $9 trillion in market capitalization, or 14% of the global market. The biggest portion of this total is comprised of the country's vast onshore (domestic) market, which represents about $6 trillion in market capitalization, or 9% of the global equity market. Another $3 trillion of Chinese stocks are traded offshore in the U.S., Hong Kong, and Singapore, and account for 5% of the global market.
According to a McKinsey study, more than 75% of China's urban population will be considered middle class by 2022, while 54% will be deemed upper-middle class ("Mapping China's Middle Class," Barton et al., 2013). As the upper-middle class expands, Chinese consumers are expected to pursue higher-quality food, beverages, and clothing, rather than staples that simply fulfill basic needs. Expenditures on housing, cars, entertainment, health, education, and luxury products are also anticipated to grow. However, we believe research and rigorous fundamental analysis will be necessary to identify the companies most likely to benefit from the changing consumption patterns of the rising middle class.
Companies incorporated in China can issue three different classes of shares—A, B, and H. Most are listed as A-shares (i.e., shares listed on Chinese exchanges in local currency), which contribute about 65% to the total market cap of the Chinese stock market.
China A-shares have historically been inaccessible to foreign investors, but the Chinese government has opened its capital markets in recent years. In 2003 and 2011, it launched the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs to allow institutional investors to purchase China A-shares. In 2014 and 2016, it launched the Shanghai-Hong Kong Stock Connect and the Shenzhen-Hong Kong Stock Connect, allowing foreign investors to trade approximately 1,500 Shanghai- and Shenzhenlisted China A-shares. And during 2018, China plans to launch Shanghai-London Stock Connect.
These moves to open the market to foreign investment are a major driver of MSCI's decision to now include China A-shares in the MSCI EM Index. The opening of these markets to foreign money presents a great opportunity for investors to tap the growth potential of the Chinese market.
As illustrated in Figure 3, financials is the largest sector in the China A market, representing nearly 30% of the market cap. The sector includes several state-owned banks and insurance companies, such as Bank of China, China Life Insurance, and Industrial & Commercial Bank of China.
While energy used to be China's second largest sector, its market share has declined over the last decade. Government entities make up a large percentage of this sector, which includes the major state-owned oil companies PetroChina and Sinopec, both of which have issued A-shares.
Unlike the United States, where information technology (IT) is the largest sector within the S&P 500, IT represents only about 9% of the China A market because the majority of Chinese technology firms are listed in the U.S. and Hong Kong. In fact, the three largest Chinese tech companies—Alibaba, Tencent, and Baidu—are listed outside mainland China. Nevertheless, the local China A tech sector has grown over the last few years, with a current total market cap of more than $500 billion.
Over 50% of China A companies are state-owned enterprises (SOEs) whose executives are appointed by the government. As such, public policy objectives may override the profitability of these companies, especially in sectors where the government desires more oversight, e.g., financial and energy markets. Academic studies have explored the negative implications of state ownership regarding issues ranging from corporate governance to operating performance (China Journal of Accounting Research, 2011).
The high level of exposure to underperforming SOEs in a cap-weighted index may make taking a purely passive approach to investing less efficient. Active managers have the resources to identify more attractive opportunities across individual companies and sectors. Our research found that SOEs are generally less efficient and less profitable, traded at higher multiples, and have higher leverage (Figure 4).
The China A stock market is liquid—shares have higher trading volume relative to shares outstanding compared to U.S. and MSCI EM stocks. In fact, more than 50% of China A companies have over 1% of their floating stock traded (i.e., number of shares available for trading). Compare this to 40% in the U.S. and only 10% in other emerging markets.
Despite the high level of liquidity, investors still face certain liquidity constraints when investing in China A-shares. For example, trading can be halted before announcements of certain important news. China's stock market also has a circuit breaker rule, which constrains the daily stock price movement between -10% and +10%. Trading is suspended for the rest of the day if the daily limits are reached. When the market is under stress, as many as 50% of companies can hit this limit, imposing liquidity constraints for investors (Figure 5).
Unlike the U.S. stock market, which is dominated by institutional investors, the China A market is dominated by retail investors. Excluding the shares held by insiders, retail investors hold more (See Figure 6) than 75% of the China A market. The circuit breaker mechanism exists, in large part, because of the episodic bursts of volatility caused by the high number of retail investors in the China A-share markets.
Our research has shown that retail investors can sometimes make investment decisions based on speculation versus fundamental analysis, which can lead to irrational behaviors such as herding. When investors all move in the same direction, correlation of stock returns increases. Indeed, correlation among retail-dominated China A-shares reached nearly 70% during market stress periods in 2008 and 2015. (Source: American Century Investments.) While herding behavior can lead to heightened volatility, it can also present significant mispricing that can be exploited by skilled active managers.
China has a special regulation on companies experiencing repeated losses. A company receives "special treatment" if its net profit is negative over two consecutive fiscal years. These companies are required to add "ST" before their original share names, making them less attractive to investors. Daily price movements of ST companies are restricted within +/-5%, versus +/-10% for other stocks. They will also be more closely and strictly audited and supervised by regulators. As a result, distressed companies in China may manipulate their earnings and cash flows to avoid "special treatment."
As illustrated by Figure 7, only 28% of Russell 3000 companies that reported negative return on equity (ROE) in 2016 were able to recover and post positive ROE in 2017. In China, that number is significantly higher, with nearly 50% of China A companies that reported negative performance in 2016 claiming they had positive ROE in 2017. Investors should understand these nuances and be cautious when using traditional fundamental factors to evaluate China A stocks. This is an area where active management can be helpful in flagging signs of manager manipulation.
Non-Chinese investors who want to benefit from the growth of the China economy can also access a limited subset of Chinese stocks listed outside mainland China. For example, the "BATs," (Baidu, Alibaba, and Tencent) are the Chinese equivalent of the FANGs (Facebook, Amazon, Netflix and Google) and have enjoyed a great run over the past three years, with prices almost doubling on average. (Source: FactSet.) These stocks are listed on U.S. and Hong Kong exchanges.
Investors can also get exposure to China by investing in non- Chinese companies with revenues from China. We identified about 50 U.S. companies with more than 30% revenue exposures to China, and 100 with over 20%, across industries including semiconductors, hotels, electronic equipment, building products, personal products, and media. (Source: Compustat, Quandl.) Familiar names include Wynn Resorts, Marvell Technology, Intel, and IMAX Corp.
An active approach that seeks to identify opportunities inside and outside China may provide the best opportunities to profit from Chinese growth while managing risk and maximizing return potential.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.
Portfolio managers are not licensed by the Hong Kong Securities and Futures Commission to perform any regulated function in or from Hong Kong. Furthermore, none of the portfolio managers are located in or operate in or from Hong Kong.
This information is for educational purposes only and is not intended as a personalized recommendation or fiduciary advice. There are different options available for your retirement plan investments. You should consider all options before making a decision. Our representatives can help you evaluate all of your distribution options.
References to specific securities are for illustrative purposes only, and are not intended as recommendations to purchase or sell securities. Opinions and estimates offered constitute our judgment and, along with other portfolio data, are subject to change without notice.
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