A contrarian approach to A-share investing

China’s A-share market is the second largest in the world but dominated by retail investors. Active managers can add significant value by exploiting behavioural biases that arise from such a market.

Sep 2018

The trading volume in China’s domestic market (A-shares) dwarfs that of the US (see Fig.1a) although its market capitalisation is just over one-fourth the US’ (see Fig.1b). Turnover, a proxy for market speculation, in A-shares is about four times as high as the US. This is perhaps not surprising, with retail investors accounting for 85% of total trading volume in the China A market. In the US, on the other hand, institutions own about 78-80% of the large-cap and small-cap equities1.

Fig 1a: Top 10 stock markets in the world                                       Fig 1b: Top 10 stock markets in the
(by 3-month average daily value traded)2                                      world (by market capitalisation)3

Behavioural biases distinguish individual investors from the rationale decision makers which financial theories assume. Particularly in a market that is dominated by retail participation, behavioural biases are even more prevalent.

Behavioural biases in the Chinese A market

The penchant for glamour stocks of small start-ups, for example, is particularly high in China4. This is despite research indicating that default risks of some of these stocks are higher5. This behavioural bias is known as the Lottery effect where investors accept a high chance of poor returns for a slim chance of winning, akin to winning the lottery.

“Availability heuristic” is another behavioural bias where investors choose to rely on easily available information to make their investment decisions. This is particularly tempting in the China A-share market with its universe of over 3,500 shares and limited research coverage.

News flow, for example, is a significant driver of market movements in the Chinese A-share market, sometimes with surprising outcomes. The Financial Times recently reported that when China proposed to eliminate presidential term limits in February 2018, which allowed President Xi Jinping to hold on to power indefinitely, a host of local stocks with “emperor” in their name rallied sharply.

Research on the Chinese A share market also revealed that speculation contributes to herd behaviour, where investors follow each other investment decisions despite their own beliefs6. The high level of retail investor participation in the A share market makes it more susceptible to herding.

As seen in Fig. 2, the valuation differences between stocks issued by the same companies but traded on different exchanges in Hong Kong (H-shares) and China are a reflection of the inefficiencies in the A-share market driven partly by behavioural biases.

Fig 2. Chinese A-shares trade at a premium (above 100) to H-shares most of the time7


The prevalence of behavioural biases in the China A share market, perhaps more so than other market at this stage of its development, offers a wealth of opportunities for active managers to exploit.

A contrarian approach to investing

We believe that a disciplined investment approach that seeks to exploit the price anomalies resulting from behavioural biases can add value to investors over the long term. As behavioural biases can affect both risk appetites and investor expectations, a focus on fundamentals anchored around valuation will go a long way.

At Eastspring, the Value Equities team focuses on companies with significant differences between market price and the absolute value of their long-term sustainable earnings. In addition, relative valuations, as compared to peers and their own history, also enable us to identify outliers.

Our investment approach is anchored by our belief that market prices do not always reflect the true value of the underlying stocks – rather they tend to over or under shoot. The team is on the constant look out for mispriced assets, which can be uncovered only through rigorous analysis and the discipline to look through current market “noise”.

For example, this year, many Chinese retail investors have sold off A-shares on concerns over the China-US trade disputes. This has driven the prices of cyclical stocks lower to a forward price to earnings basis of 12 times (see. Fig.3) – more than one standard deviation lower than their 3-year average8. Cyclicals appear to be over-sold, potentially presenting opportunities for investors to take advantage of.

Fig 3. Forward price-to-earnings (P/E) multiples9


Integrating ESG factors

Beyond traditional financial metrics, the team also integrates environmental, social and governance (ESG) factors in our stock screening process. This is despite the fact that only 2% of MSCI China A International Index constituents publish sustainability reports and disclose financially relevant ESG metrics, compared to 34% of MSCI ACWI constituents10.

We believe that an assessment of ESG issues is important in understanding sustainable earnings, and may incorporate risks associated with a company’s “social agency” and ongoing franchise.

We adjust revenue forecasts, for example, to account for labour standards or potentially stricter environmental regulation. The team also considers health and safety issues when analysing the sustainability of operating profit margins.

Success goes to the discerning minority

Rigorous research and patience hold the key to uncovering market outliers in China.

Under-priced companies may remain out-of-favour for an indeterminate length of time.

But with the passage of time, greater participation of institutional investors (Stock Connect And Trade Disputes: What They Mean For China A-Shares) will make China’s domestic markets gradually less prone to human misjudgement, thereby closing the mispricing anomalies.

Significant valuation upside will compensate for the time it may take for the market to realise value – the sphere of investing where success goes to the discerning minority.