China A-shares and MSCI – Much Ado about ‘Something’?

Is it is worth investing in China equities now that MSCI has added China A-shares to its indices, Jonathan Wu writes.

Since the announcement in June, I’ve received endless queries about what I thought of MSCI adding China A-shares to the MSCI China and MSCI Emerging Market indices. The key questions that have been asked can be summed up by the following three:

• Is this a game changer for the Chinese equities market?
• Is this the time to invest in China equities? and
• If yes, what is the best way to access the market and with what investment philosophy?

Is it a game changer for the Chinese equities market? 

Yes and no. Firstly, we need to address how we finally came to this point in the story today. MSCI has been tossing and turning over adding China A-shares to its indices over the last four years. 

We have seen consultation paper after consultation paper discussing their various concerns surrounding the complicated nature of adding a partially capital controlled market into their indices. For the last three Mays, we received an announcement in the negative as to why they won’t be adding China A-shares “this” year. 

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In May this year though, their consultation paper became more specific, and the 448 stocks they initially planned on adding to the indices became 169. 

This was due to a range of issues which culled most of the original 448, including 178 mid-cap securities, 61 A-shares which also had H-share constituents, 32 securities that had been suspended for more than 50 days and another eight securities which were not eligible for stock connect. This brought the final number down to the aforementioned 169. 

What was probably the biggest surprise for us watching on the sidelines was the variance in the final number of securities announced in June which took the number up from 169 only a month ago, to 222.

So back to the question, yes, it is a game changer from the perspective that MSCI finally pulled the trigger, but no, as in there is no rush to be investing into A-shares at the moment.

The yes relates to the fact that global capital markets now recognise China’s ongoing opening up of its capital markets. This is only the beginning, but it is an important beginning. One of the key concerns of global investors over recent years, regarding investment into the

Chinese equities market, has been volatility. 

The primary reason why we see high volatility levels is because China’s A-share market is made up of over 90 per cent domestic retail investors. In any other fully open developed equity market, we see a base level of support from institutional investors, who trade less and therefore the market as a whole exhibits a lower level of volatility. 

As more A-shares are included in global indices over time, and with a greater weighting, what we’ll see is a reduction in volatility as passive investment from large institutional investors account for a greater portion of the Chinese equities market.

The second issue that concerns investors is liquidity and the ability to get out of the market. This concern was heightened during the “flash crash” in January 2016. Listed companies voluntarily suspended trading of their stocks for no good reason other than to ensure their share prices didn’t drop further from the irrational fear-driven sell off by retail investors. 

This exacerbated market fears. MSCI has taken a strict line with these companies, removing them from the stock list for index inclusion. The Holy Grail for any listed company as we know, is to be included in an index as that guarantees support for their stock by passive investors (not that we advocate passive investment for any market where irrational behaviour may exist). The strict stance by MSCI will help ensure less companies over time go into voluntary suspension to protect their interests of index admission.

So that’s the yes part of the game changer question. The no part reflects the initial scale of implementation of A-shares into the MSCI China and Emerging Market indices. MSCI has taken an extremely cautious approach in its initial application by only including five per cent of the market capitalisation of the underlying stocks for weighting purposes. This means that a USD $100 billion ($125.88 billion) company will be counted as if it has a market cap of USD $5 billion when added to the MSCI China and Emerging Market indices. 

This is why right now, there’s little reason to be jumping up and down like a kid in a candy store, feeling compelled to load up on China A-shares in anticipation of passive money. In saying this, the weighting will most certainly grow over time as the market further opens, underpinning a long-term steady bull market in China.

Is it time to invest in China equities? 

The short answer is no. This must be shocking to you as a reader of this article that I don’t suggest you invest in China at the moment.

Let me clarify – Greater China equities is made up of a range of markets which include China A, B, H, Red Chips, Hong Kong, and Taiwan. If you want to invest in A-shares because of MSCI, then you’re going about things the wrong way. There have been many commentators with far more insight into developed market equities who have been calling for a correction in markets for quite some time. Price-to-earnings (P/Es) ratios suggest developed market equities are not cheap by any means. At the same time, China A-shares are in fact slightly more expensive than Australian shares. 

So, if you’re looking to invest in China A-shares because of the potential implications of MSCI’s inclusion of A-shares, you shouldn’t. On the other hand, Chinese companies listed in Hong Kong (China H-shares) have far lower price-to-earnings.

If the soothsayers are right and we are to strap in for a well overdue correction, you want to be in a market that is already attractive to start off with.

Chart 1 shows that the competition isn’t even close with the US just under 20x, the world at around 17.5x and Australia at 16x, compared to China H-shares at 8x. Chinese equities listed in Hong Kong is where you want to be, offering not only attractive valuations, but a fully open and free capital market. 

What then escalates the case is the context of performance over the last 12 months. China H-shares have returned 23 per cent and its P/E is still only half that of Australian shares. Enough said.

If yes, what is the best way to access the market and with what investment philosophy? 

In the current market conditions, you will need to find gems in the market in order to perform. Since 2011, you could have effectively invested blindly in developed market equities and would have outperformed term deposit rates. But going forward, whether or not you want to admit it, this is going to be a lot harder. 

Because of the power of “rational reasoning” (and I use the term loosely), we see plenty of commentary on how we can justify higher price-to-earnings ratios. However, companies back in the world of reality can only sustain high P/Es when their earnings increase exponentially in perpetuity. This is not something I can foreseeably see based on recent market newswires. If you have ever seen the “cycles” chart for equities, you would note that the day before the correction, the phase is titled “euphoria”, and the one just before that is“thrilled”. We are thrilled now, and you definitely don’t want to wait for euphoria before acting in your clients’ best interests.

The way you want to be accessing China then as alluded above is to focus on two things. One – invest through Hong Kong which provides an open, transparent and liquid market. This is also the more attractive market based on valuations. Secondly – look for structural inefficiencies by researching deeply into the market. 

This means that a typical “global fund” cannot offer this value add to your clients. Would you allow a US-based manager to invest in Australian equities for you? I would guess no, because you know you need local specialists to see things beyond the surface. For China, this means finding similar companies which are performing strongly from an earnings standpoint, but where the A-shares are expensive, invest in its Hong Kong listed counterpart. 

An example could be two dairy companies, both China based, but one listed in the domestic A-share market and the other in the Hong Kong H-share market. The H-share company is trading at a 25 per cent discount to the A-share listed one, so you buy the H-share. While that sounds easy, the ability to finding highly similar companies is the real skill, and only a China specialist can offer this level of in-depth research and insight.

So, while MSCI adding China A-shares to its indices is a step in the right direction, it’s nothing you can meaningfully act on today nor would you want to as a rational investor. Take a step back, smell the roses and use a level head when assessing how to best invest in China. 

Jonathan Wu is executive director/chief investment specialist at Premium China Funds Management.