Amid growing fears surrounding the trade disputes between China and the US, as well as the softening of Chinese economic data in recent months, the Shanghai Composite index saw heavy sell-offs.

That said, as long-term investors, we are not overly concerned about short-term market noise and fluctuations, though we do keep a close watch.

The current situation may lead to more attractive opportunities in China’s domestic markets for discerning investors to exploit.

Over time, as China matures as a market rather like Japan and the US, the MSCI inclusion1 will expand market breadth and provide greater opportunities to investors.

Opportunities in large-cap A-shares

Large-cap A-shares have been quietly outperforming since November 2016, thanks to the introduction of Shanghai Stock Connect2 . The scheme, extended in late 2016 to encompass the Shenzhen market, allows foreign investors to trade A-shares as easily as Hong Kong-listed China H-shares.

Since then, large-cap A-shares, particularly those offering attractive dividend/earnings yields and price-to-book multiples, have turned around and begun to outperform the broader Shanghai and Shenzhen A-share markets (as seen in Fig.1).

What we have seen is that the large-cap dominant CSI 300 index has returned 10.6% p.a. since November 2014, while its 100 most attractively priced constituents (CSI 300 Value) gained 18.1% p.a.

Figure 1: Performance of large-cap A-shares in past 10 years 3
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This price recovery supports the idea that foreign investors find large caps more appealing (as reflected in Fig.2), especially those with attractive valuations (represented by CSI 300 Value).

Figure 2: Stock Connect inflows coincide with outperformance of large-cap A-shares4
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It is also worth noting that Northbound buying turnover, in other words the purchase of A-shares by foreign investors through Stock Connect, brought a net capital inflow of RMB326 billion5.

Exploiting the additional breadth

The Stock Connect scheme, which relieves concerns over cross-border capital mobility, helped support MSCI’s decision to include A-shares in its indices.

It is believed that post-inclusion, large-cap A-shares will likely benefit from the growing foreign demand, largely the institutional interest.

This is especially true since the new MSCI A-share constituents have larger market capitalisation, yet enjoy lower valuations and healthy earnings growth.

Estimates show that the average market capitalisation of these new constituents is about RMB 125 billion (USD19 billion), much larger than the RMB15.7 billion (USD2.5 billion) market cap for the average A-share6.

We can see that trading about 10.4 times their 12-month expected earnings7, valuations for the new MSCI constituents are similar to the CSI 300 index, which are, as we know, attractive by historical standards (see Fig.3).

Figure 3: Z-scores (3-year rolling Price-to-Earnings) of the large-cap-dominated CSI 300 index8
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In addition, the new constituents are expected to register a robust earnings growth of 20.1% over the next 12 months9.

What this means is that rather than just focus on Hong Kong and other offshore markets, it presents opportunities for us to exploit the mispricing and anomalies of A-shares.

The good news is that despite their stronger performance in recent years, China’s A-share large caps are still priced at lower valuations relative to their smaller counterparts (see Fig.4a). This contrasts with Hong Kong and the US, where large-caps trade at a premium (see Fig.4b).

Figure 4: Valuation disparity in Hong Kong, Mainland China and the US10

4a: Mainland China (A-shares) P/B & P/E                                      4b: Hong Kong and the US (P/B)

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It is expected that such disparity will likely narrow amid greater institutional interest and foreign inflows through Stock Connect and the recent MSCI inclusion.

At this stage, despite a very small weight of 0.39% in the MSCI Emerging Market index (at a 2.5% partial inclusion factor), foreign institutional buying is expected to increase. Both passively and actively managed investment portfolios are obliged to include the 233 China A-shares that have been added to the MSCI Emerging Markets index.

When China A-shares become fully included in the index, their weighting can potentially be as high as 13% of the benchmark – expanding the breadth of investment universe.

The less popular tech companies

Taking full advantage of our bottom-up investment process, we continue to search for attractively-priced companies in many unpopular corners of equity markets.

So, where are the attractively valued opportunities?

Within the A-share large caps, clusters of these can be found in the technology space.

From a historical standpoint, for example, CSI 300 Information Technology is now trading more than one standard deviation below their long-term average (see Fig.5).

Figure 5: Z-scores of 3-year rolling P/E: China’s domestic versus offshore markets11
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The less popular tech A-shares have lagged the broader CSI 300 by 18% points over the last two years. On the contrary, their offshore counterparts in MSCI China Information Technology beat MSCI China by 29% points12.

This suggests that there is room for some of these undervalued tech A-shares to play catch up with their offshore counterparts in Hong Kong and the US after the MSCI inclusion.

Towards full inclusion

With full MSCI inclusion remaining on the radar of Chinese policy makers, we are likely to see China further deregulate its capital markets.

At the same time, management teams will continue to improve their corporate governance to catch up with international standards and attract greater institutional interest.

With the rising participation from institutional investors, their longer-term perspective will make Chinese domestic equity markets more rational as we move towards full MSCI inclusion.

Nevertheless, investors will need patience and rigorous research to realise the true potential in China A-shares, which offers a more accurate reflection of China’s economic progress.

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