Embracing Change in Chinese Equity Markets

John Lin, Chief Investment Officer, China Equities: China is the world’s second-largest economy, with a large domestic equity market featuring a diverse set of companies. The market is very liquid and, until about 10 years ago, was not really accessible to foreign investors. Even today, China remains underrepresented in global indices despite its economy’s large size.

We think that an investment in the China domestic A-share market can be strategically rewarding for most types of investors. The Chinese economic cycle usually isn’t synchronous with most Western economies. Market liquidity and sentiment follow their own rhythm, meaning that an allocation to China A-shares also offers diversification benefits. In fact, our research suggests that adding A-shares to a standard emerging-market allocation can provide sizeable benefits to investors by improving risk-adjusted returns.

The market is also attractive in terms of its potential for uncovering superior companies that are flying under the radar. Onshore Chinese companies tend to be covered by far fewer brokers than their developed-market counterparts. In addition, the market is dominated by retail investors and, as a result, can be highly inefficient, which creates opportunities for active managers.  

John: Back in in 2009, the world was in the throes of the global financial crisis. At the time, the Chinese economy was a shining star against a backdrop of recessions in developed markets. Over the last decade, China’s annual GDP growth has decelerated from double digits to below 5%, as its economy has matured and geopolitical competition with the US and its allies has intensified.

In addition to the economy, the financial market infrastructure had also improved significantly over the years. China A-shares’ weight in the MSCI Emerging Market Index has been increasing steadily over the years. Under the current inclusion factor of 20%, China A-shares’ weight is 5.2%. But over the long term, when the inclusion factor increases to 100%, China’s weight will increase to 21.4%, which should lead to increased flows into this asset class. Meanwhile, the Chinese government is committed to improving market access and the quality of its equity markets through recent policy actions such as the broadening of the registration-based IPO scheme.

The market itself has been evolving too. China’s equity market seems to be following the familiar path of other “tiger” economies in Asia, such as Taiwan and Korea, as investors shift their focus from traditional growth names to companies with strong cash flows that have been overlooked by the market. As Korea and Taiwan decelerated into low-single-digit GDP-growth economies at the turn of the millennium, value stocks began to outperform. Indeed, the MSCI Korea Value Index has outperformed the broader index since 2000. We think China will likely follow the same path. After all, with all the negative headlines in the press about China’s economy and its decelerating growth, one would be hard-pressed to call China “the growth market” that it was in the 2010s.

John: We apply AB’s time-tested value philosophy, honed over the past three decades in other parts of the world, which targets the same human behavioral biases that exist in all global equity markets. In a retail-dominated market such as China A-shares, these biases can be particularly pronounced—and exploited by skilled managers.

But while the China A-share market is much more inefficient than developed markets, investors must also be able to stomach much higher volatility. We believe that this is where active management can add the most value to investors. Skilled managers with a good feel for the market’s pulse can successfully navigate the choppy periods by exploiting opportunities when sentiment is bad and realizing gains when markets become exuberant.

While most professional investors in the Chinese equity market are growth oriented, we differentiate ourselves by applying a stringent value philosophy, using a combination of our quant tools, deep fundamental research and extensive on-the-ground grassroots research. This “quantamental” investment philosophy can be found in some developed markets, but is relatively uncommon in the China A-share market.

John: First and foremost, we distinguish between companies and country. Against a backdrop of slower GDP growth, there are still a set of solid companies that have become very good at what they do.

In the industrial sector, companies like bus-maker Zhengzhou Yutong Bus, truck engine–maker Weichai Power and forklift manufacturer Hangcha have become leaders in their respective industries. Chinese companies in machinery, home appliances and technology hardware, to name a few, dominate their industries in China and are emerging as budding “multinationals” with steadily rising export shares. Some are strong in emerging markets; others, like home appliances, are rapidly gaining market share in the US and Western Europe.

We believe that companies like these make for great long-term investments because they have durable market leadership backed by competitive products and services, solid cash flows and smart capital deployment. Increasingly, these companies will be able to generate growth regardless of Chinese domestic economic fluctuations, offering attractive long-term investment potential.

Another set of investments are boring state-owned enterprises that generate steady, forecastable cash flows yet trade at a substantial discount to their developed-market counterparts because domestic investors historically overlook the benefits of steady cash flows. Companies like toll road operators, port operators and railway operators can add stability to the portfolio and enhance overall return through their generous dividends.

John: After going on the road, we have no doubt that in the short term, the pressure on economic growth is real and strong. Everywhere we visited, we saw evidence of the deep scars left by the last three years—whether it was in cautious consumer behaviors or in small and medium-size enterprises that ran out of funds. We believe that the recovery will be uneven and volatile. Also, additional policy support from the government would go a long way toward stabilizing confidence, which is very much lacking and therefore hindering the recovery process. At the same time, the entrepreneurial spirit that makes China Inc. the most successful economic story of the last 50 years remains very much intact. That spirit is one reason why we sincerely believe that China will remain a vibrant equity story for the coming decade.

That said, it’s also clear that risks today look different than they did when we first launched the fund. For one thing, an investor needs to pay attention to and understand the geopolitical risks embedded in the companies they buy. Domestic political risks must also be carefully considered.