A, B, H, P-chips, P-notes, S-Chips, the letters in front of Chinese stocks tend to confuse neophytes. As China becomes a growing priority in 2021 for investors, both private and institutional, it is timely to look at the domestic equity market, namely A shares, companies listed in Shanghai and Shenzhen, and denominated in renminbi, a little-known frontier worth exploring.
Quick historical reminder. Most foreign managers invest in China by trading offshore H shares, namely Chinese companies listed in Hong Kong, widely represented in international stock indices, but which are above all large Chinese banking and industrial groups with a less attractive growth profile. than new economy companies, with a few notable exceptions including Tencent and Alibaba which are listed in Hong Kong.
B shares, introduced in 1992 to attract foreign capital to onshore markets, are domestic dollar or Hong Kong dollar listed shares that are now on the verge of extinction, having gradually lost their raison d’être as China collapsed. launched in a phenomenal movement to reform its financial markets, by opening its domestic market and introducing in 2002 the status of QFII (Qualified Foreign Institutional Investor, which requires a specific license and the granting of an investment quota), then R-QFII (Renminbi Qualified Foreign Institutional Investor) in 2011 and finally Stock Connect from 2014 which allows all investors to buy and sell A shares through the Hong Kong stock exchange.
The second largest stock market in the world. Market A has more than 4,500 companies, half spread over Shanghai and Shenzhen. With a market capitalization of 11 trillion US dollars, it is today the second largest market in the world. Unlike most emerging markets, foreign investors represent a very small minority, holding only 3.8% of the market.
For technical and regulatory reasons, the index provider MSCI now gives it a weight of only 5% in the MSCI Emerging Markets index, but A shares could represent nearly 50% of this index within a few years. . Their virtual absence in global portfolios and international indices implies a minimal correlation rate with other financial assets and therefore contributes to a solid portfolio diversification.
An El Dorado for stock picking? This huge market has specificities that make it very interesting for stock pickers: it is young and very dynamic, with daily liquidity of more than 160 billion dollars. The share of retail investors has gone 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 products, is to be envied, in comparison with emerging countries producing raw materials.
Or the Wild Far East? In parallel with this institutionalization of the market, we have observed an improvement in governance standards, even if the market as such often finds itself at the bottom of the rankings of rating agencies.
An essential reason for the weakness in these rankings is linked to the lack of information provided by companies, even if the reform of the Corporate Governance Code in 2018 (the first reform since its adoption in 2002) represents progress by instituting recommendations (but no obligations) regarding environmental considerations, societal responsibilities and investor protection. Today, around 20% of listed companies publish an ESG report.
It is encouraging that responsible investment practices are becoming more common. There are now 51 Chinese signatories of the UN PRI association’s responsible investment principles, a remarkable step forward (they were only 7 in 2017). The national priorities concerning the fight against pollution for several years and now decarbonization lead to a rotation of investments in green sectors, and a strengthening of the regulatory framework for polluters.
The feminization of boards of directors is lagging behind and increasing slowly, only 13% of directors are women (11% in 2018) and 29% of Chinese member companies of MSCI China have a completely male board of directors (against 17 % in the world). Chinese CEOs, on the other hand, represent 6% of Chinese CEOs (compared to 4.8% worldwide). As the market becomes more mature, the level of shareholder concentration decreases and investors vote more than before, but the voting turnout remains low, with only 26% minority shares.
Our approach. Investing in A shares since 2013, and in emerging countries since 1997, our analytical work on the ground and the importance of long-term prospects are the same in China as in Russia or Brazil. But as a shareholder, we note that the role and power of boards of directors differ, and we prefer dialogue with management teams to move issues forward. The questions on which we most often engage relate to the discipline of capital allocation, specifically in semi-public companies, the transparency and reliability of information and the rotation of auditors, management compensation programs and ‘alignment of sustainable development priorities.
After two consecutive years of good stock market performance, notably + 38.6% in 2020, the market is valued at 17x for 2021, which is lower than the MSCI World Index (22x). Less affected by geopolitics and less vulnerable to the risks of regulatory tightening experienced by the Internet securities sector (listed offshore), it is a market that should be supported by the dynamism of economic growth, estimated at 8% for 2021, by the growth of the local asset management market and the appetite of foreign investors.
Karine Hirn is founder of East Capital.
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