There are good reasons to be cautious about A-shares. Investors need to navigate structural imbalances in China’s debt-laden economy, concerns about the government’s macroeconomic stewardship and the large contingent of state-owned enterprises in the market.
Ignoring A-shares, however, means missing the full potential of China’s expansion. For example, the onshore market is full of growing healthcare companies serving the country’s aging generation. Many technology firms from the Shenzhen market are inaccessible offshore. The market also provides access to China’s explosive consumer growth and local brands popular with the growing middle class; shares of Kweichow Moutai, the distiller of a popular grain liquor, more than doubled on the Shanghai Stock Exchange over the last 12 months due to swelling demand.
What Does It Take?
But what does it take to invest effectively in China A-shares? We think three key competences will determine success:
- Boots on the ground—There’s no substitute for research heft. Funds must be armed with field research from professionals with deep experience on the ground in China. These teams need to be fully versed in the nuances of China’s growing economy, know the players inside and outside the companies, and be able to identify firms with good governance. It’s also important to make sure that an EM fund has enough analysts to cover the market effectively.
- Quantitative capabilities—There are more stocks listed in the China A market than in either the Nasdaq Stock Market or New York Stock Exchange. MSCI’s inclusion of 222 A-shares into its EM benchmark increased the number of stocks in the index by more than 25%. Moreover, there are now more than 1,900 A-share stocks accessible to foreign investors through the Stock Connect scheme, more than doubling the universe of investible equities in China. This favors research teams already familiar with the onshore landscape, in our view. We also think funds that know how to combine quantitative tools with fundamental analysis will have an edge when combing the vast pool of A-shares to identify portfolio candidates.
- Active advantages—Research shows that active investing strategies are especially effective in emerging markets, which are less efficient than developed markets. In China’s A-share market, which is dominated by retail investors, inefficiencies abound. These retail investors often lack critical information about company performance, and information dissemination is imperfect. For example, it can take months for the market to respond to sell-side analyst upgrades. This environment favors a hands-on approach that focuses on long-term fundamentals and investment themes.
A-Shares Are Different
Investing effectively requires a thorough understanding of how China’s top-down politics ripples through the economy. Though politicians’ rhetoric can be discounted in Western markets, China’s political class often sets the rules in the market.
For example, the government’s focus on reducing air pollution is creating winners and losers in the transportation industry. A curb on diesel trucks is benefiting Chinese rail operators and vehicle manufacturers that meet emissions standards.
Funds must be able to identify companies with interests that don’t align with minority shareholders. Many state-owned enterprises will prioritize public responsibilities over profit maximization. Meanwhile, professionals need to be familiar with tycoons who might siphon off profits for side projects.
To pilot a portfolio through these challenges, familiarity with the onshore landscape is indispensable. But we think many EM investors may not be equipped with what it takes to find stocks with the strongest return potential. Ask your fund manager the right questions to find out whether they are ready—or not—to fully participate in a new year of opportunities across all of China’s stock markets.
