Most foreign managers invest in China by trading shares of Chinese companies listed in Hong Kong, mainly large banking and industrial groups with a growth profile less attractive than the companies of the new economy.
A, B, H, P-chips, P-notes, S-Chips, the letters in front of Chinese stocks tend to confuse novices. As China becomes in 2021 a growing priority for investors, both private and institutional, it is timely to look at the domestic equity market, i.e. A-shares, companies listed in Shanghai and Shenzhen and denominated in Renminbi, a little known frontier that deserves to be explored.
A quick historical reminder.
Most foreign managers invest in China by trading offshore H-shares, i.e. Chinese companies listed in Hong Kong, which are widely represented in international stock market indices, but which are primarily large Chinese banking and industrial groups with a less attractive growth profile than new economy companies, with a few notable exceptions, notably Tencent and Alibaba which are listed in Hong Kong.
The second largest stock market in the world.
Market A includes more than 4,500 companies, half of which are located in Shanghai and Shenzhen. With a market capitalization of US$11 trillion, it is now the second largest market in the world. Unlike most emerging markets, foreign investors are a very small minority, holding only 3.8% of the market.
For technical and regulatory reasons, the index provider MSCI currently gives them a weighting of only 5% in the MSCI Emerging Markets Index, but A-shares could account for almost 50% of this index within a few years. Their virtual absence in global portfolios and international indices implies a minimal correlation with other financial assets and therefore contributes to a solid portfolio diversification.
An Eldorado for stock picking?
This huge market has specific features that make it very interesting for stock pickers: it is young and very dynamic, with a daily liquidity of more than 160 billion dollars. The share of retail investors has risen from 95% of the free float when the market was created in the early 1990s to 70% in 2010 and now 50%; as their behavior is not always rational, this creates attractive opportunities for managers who are not familiar with fundamental and structured analysis methods.
The great diversity of investment themes and sectors, particularly in services and consumer goods, is to be envied, in comparison with the emerging countries producing raw materials.
Encouragingly, responsible investment practices are becoming more common. There are now 51 Chinese signatories to the UN PRI Principles for Responsible Investment, a remarkable progress (there were only 7 in 2017). The national priorities of several years of pollution control and now decarbonization are leading to a rotation of investments into green sectors and a strengthening of the regulatory framework for polluters.
The feminization of boards of directors is lagging behind and is slowly increasing, with only 13% of directors being women (11% in 2018) and 29% of MSCI China member companies having an all-male board of directors (compared to 17% globally). Chinese CEOs, on the other hand, represent 6% of Chinese CEOs (compared to 4.8% globally). As the market becomes more mature, the level of shareholder concentration is decreasing and investors are voting more than before, but the voting participation rate remains low, with only 26% of minority shares.
30% of the country’s household purchases made online
More than 30% of the country’s household purchases are now made online, the highest percentage in the world. Alibaba, China’s e-commerce leader, has recorded another long list of successful innovations in 2020 with Taobao Livestreaming, Taobao Deals, Tmall Luxury Pavilion and a megadata-based news feed product. The Chinese government will likely continue to tighten regulation of the digital sector, but we believe it will still seek to strike the right balance between innovation and regulation. Alibaba, because of its role as an Internet innovator, will continue to be important to China’s ambition to become a high-tech nation.
Other players in the real economy are also worth mentioning:
SAIC, China’s leading automaker, has seen its share price appreciate thanks to the first signs of sales recovery in the Chinese automotive market; Midea, a well-known producer of heating/ventilation/air-conditioning and electrical appliances, has also benefited from both rising domestic consumption and strong exports. Taiwan Semiconductor Manufacturing Company (TSMC) remains a leading chip manufacturer as it became clear in 2020 that Intel had fallen behind in the race for ever-smaller chips.
The ‘stock connect’ program has added a new dimension to the opening up of the capital markets. Foreign investors now hold about 10 percent of the market capitalization of mainland Chinese companies after investing more than $50 billion last year (and more than $330 billion since the launch of the Connect program in 2014).
With the signing of the Global Regional Economic Partnership (GREP), China has also significantly increased its influence in the Asia-Pacific region. In the longer term, the GRP is expected to have a positive impact on the future growth of Asian markets. The agreement marks a further eastward shift in the epicenter of the global economy. For China, considered the driving force behind the agreement, it opens up the possibility of further extending its economic influence in the Asia-Pacific region”.
What really sets China apart from other countries is its willingness to embrace new technologies, and its growing importance is still in its infancy.
Why China and why now?
Reluctance to invest in China seems understandable. The effects of the COVID-19 pandemic, China’s political relationship with the United States and the potential structural consequences for companies’ global supply chains are certainly worrisome. In recent years, however, China has been reducing its indebtedness and rebalancing its economy from investment to consumption. The country’s economic growth has not been as robust as it has been for years and is now driven by the private sector. But perhaps the most important changes in China are the accelerated adoption of technology, increased economies of scale, and the strengthening of the competitive advantage of some leading technology companies. Baillie Gifford is convinced that in the long term, the future belongs to China, and therefore also to long-term investors in innovative Chinese companies.
There are tremendous opportunities for investors in China.
Over the last decade, China has generated about a third of the world’s GDP growth. Its middle class is now the largest in the world, while its economy and stock market are the second largest in the world. The world’s most populous country has a domestic market of more than 1.4 billion people. But what really sets China apart from other countries is its willingness to embrace new technologies, and China’s growing importance is still in its infancy.
Market inefficiencies, partly created by individual investors …
For investors, knowing that the stock market offers promising opportunities is even more crucial. In our experience, the Chinese equity market remains one of the most inefficient in Asia to date. This is partly due to the predominant role played by retail investors, who account for about 80% of domestic trading volume. However, these participants often behave in a conformist manner and the holding period of securities is counted in days, not years. As a result of these inefficiencies, Baillie Gifford believes that investing in China over a five to ten year time horizon provides an additional competitive advantage.
The universe of long-term growth stocks is very broad and includes publicly traded private and public companies with the potential to become national and global champions:
Healthcare revolution –
Ping An Good Doctor, a telemedicine application based on artificial intelligence, can examine 500 patients a day and make a diagnosis twice as accurate as a real doctor. Catalyst for Online Commerce – Alibaba and JD.com have helped create the world’s largest e-commerce marketplace, with a volume greater than the combined volume of the next ten markets in the rankings. Pioneer in the launch of electric vehicles – CATL, the world’s leading manufacturer of batteries for electric vehicles (EVs), has enabled China to capture a share of nearly 50% of the global EV market. Future of food – Meituan plans to distribute 100 million meals a day using UAVs within a few years.
In China’s megacities, many people are already ordering three meals a day online. This means that newly constructed apartment buildings no longer have kitchens. Smooth financial services – Ant Group’s platform, which is already being used by a billion people, facilitates access to various types of financial services: poor people in rural communities in Inner Mongolia should have access to the same services as the president of a Chinese bank.
Why is there such a high density of innovative companies in China?
Mainly because of the steady increase in investment in research and development (R&D). China already spends more on R&D than the EU as a whole and will soon overtake the US. We are therefore convinced that a large number of leading technology companies will be based in China in the coming decades.
Market under-represented in international portfolios
It is all the more surprising that China is clearly under-represented in international portfolios despite all these investment opportunities: worldwide, China represents 18% of market capitalization, 31% of listed stocks, but only 2.5% of global investments.
As China continues to open up its market and will realize its enormous potential, investors should take an interest now and include Chinese equities in their portfolios to get a head start on the developments that are taking place. Baillie Gifford has been investing in China on behalf of its clients for several decades. At the end of June 2020, investments in more than 100 Chinese companies amounted to approximately 58 billion Dollars, representing 17% of its total assets under management.
The financial markets in China in 2021
Growth, accelerated digitalization, less currency risk: these three main reasons make it a safe bet that China’s extreme underweight in global portfolios, exposed on average to only 3% of an economy that accounts for 15% of world GNP and a large third of its growth, will be reduced over the next decade.
In 2001, China took up the challenge of joining the World Trade Organization. And to the surprise of the rest of the world, in two decades it became the “factory of the world”. In 2021, is the Middle Kingdom this time preparing to join the circuits of world finance to redraw its contours to its advantage?
While the best Chinese companies had historically turned to the American ADR market [The American depositary receipt allows foreign companies to have a listing on the American markets] to finance their development, in 2020, it was international investors who, amid the Covid crisis, moved closer to China, placing nearly $150 billion – 80% of which on the debt market.
At the same time, the largest American investment banks, ignoring the barking of President Donald Trump, were taking advantage of a regulatory change to rush to buy out the local partner of their Chinese joint venture, a sign of confidence in the future of the Middle Kingdom.
Three favourable factors
There are three main reasons to bet that China’s extreme underweight in global portfolios, with an average exposure of only 3% to an economy that accounts for 15% of world GDP and a large third of its growth, is set to diminish over the next decade.
The attraction of growth.
First of all, in the very short term, investors remain desperately looking for growth in a new cycle which, in an unprecedented way, is initially only starting up again in China. The United States and Europe will take some time to return to their 2019 levels of activity, while China’s GNP, after +2% in 2020, is expected to grow by around 8% in 2021, in line with its long-term annual trend of 5%, facilitated by the necessarily accommodating policy of the central bank.
This growth will be driven by three secular factors that are set to shape this next cycle: firstly, the forced adoption of the technological revolution, illustrated both by the construction of infrastructures for new forms of connectivity, such as 5G, and by the development of new applications, ranging from live-streaming to smart manufacturing.
Then there is the declared determination to take up the impossible environmental challenge of achieving carbon neutrality by 2060, thanks to an incredible commitment to solar and wind power, which together are expected to account for nearly 60% of China’s energy generation in 2060, compared with only 10% today. Finally, the last vector of growth is an ever insolent consumer, who is now attracted more by desire than need, sophisticate his requirements in terms of health, education, nutrition, entertainment and tourism.
The acceleration of digital era.
But more structurally, by turning to the Chinese markets, international investors will understand that the pangolin of the year 2020 is actually the harbinger of the revolution of the coming decade, that of the acceleration of the digital era. For by systematically digitizing all services to escape the middle income trap, China is reinventing itself as the new “Butler of the World” and the queen of the new economy of sharing.
A country of 7 million graduates a year has no choice but to promote the video-classroom of 3,000 students, as proposed by Youdao, the innovative subsidiary of the Netease group; overcrowded hospitals receiving 8 billion (!). 8 billion (!) in annual visits conceive their only possible salvation in teleconsultations, such as those deployed by PingAn Good Doctor; mass penetration of affordable life and health insurance products necessarily involves new digital policy designs and distribution, as implemented by new entrant ZhongAn.
greater exposure to China will paradoxically allow global investors to hedge against the risk of a currency crisis in the West, which history would have it following the economic and financial crises of 2008, as the daily rise of Bitcoin seems to indicate.
By refusing to monetize its local debt, as opposed to its American and European counterparts, and by accelerating the pilot projects of the digital renminbi, the PBOC central bank openly affirms its determination to strengthen the credibility of the renminbi against the dollar and the euro, recalling that in the “Cold Peace” with the United States, the strong country will be the one with a strong currency.
How long will Western “zinzins” still be able to resist the sirens of Chinese 10-year Treasury bonds, offering an annual return of more than 3% – 250 basis points more than the American equivalent – which, if combined with an annual appreciation of the currency by 3 to 4%, would offer an annual return in dollars or euros of around 6%-7%?
It is now better understood that the next U.S./China war will be the balance of payments war, in which China intends to try to divert towards itself a part of the world savings, notably Japanese and European, which for half a century have financed the excessive American lifestyle.
A world upside down
Welcome to 2021 in an upside down world, where Western investors will see many of their historical convictions challenged. Starting with the need to reconsider Chinese country risk, which today is illustrated by valuations that are often only half those of American competitors, reflecting equity risk premiums of around 8% to 10%, i.e. double the level observed in the West.
While one cannot deny the risks of state capitalism with “Chinese characteristics”, the West’s often too quick reading of state intervention, as recently in the case of Ant Group or Alibaba, would benefit from going beyond the simple vision of an arbitrary communist with long knives. The historical originality of the 2021 recovery cycle lies in its K-shape, an elegant concept used by macro-economists to evoke its fundamentally unequal character, amplified by the economic model of the digital revolution, where the absence of marginal cost implies that the “winner takes all. »
In a country where 600 million people still only have $150 a month in revenue, investors should expect the Chinese government to regulate the digital giants in a preventive manner by reminding them of their social responsibility, rather than letting them either prosper without limit as in the United States, or trying to slow them down in vain because it is too late as in Europe. This will not prevent growth investors from identifying opportunities born of the amazing entrepreneurial blood of the Chinese private sector, offering as a holy grail the combined sum of more than 40% of the growth in revenues and Ebitda margin.
But the main pleasure for Western investors in 2021 to exercise their intellectual curiosity about Chinese private companies will be to rediscover the benefits of analyzing the long cycle fundamentals that have made Amazon’s fortune in the West. Adopting a long-term approach is precisely what, in the B2B sector, has ensured the success of Alibaba’s diversification into logistics or the cloud, reaching financial equilibrium only now, after eight and ten years of loyal service, respectively.
Likewise, in the B2C sphere, the greatest successes of digital franchises are those that have tested the patience of investors, called upon to finance successively product concepts, construction of user communities, monetization phase, before, only in an ultimate phase, reaching financial profitability.
It is therefore in China that “thematic investment” could fully blossom in the next decade, naturally with the painful inherent risks of hasty fanaticism, dethroning the value investing and growth investing so dear to the West.