The inclusion factor of A-shares in the MSCI EM Index is in the process of increasing this year from 5% to 20%, which is expected to lead to foreign inflows. What does this mean for companies listed in China?
“This inclusion effectively will increase demand for A-shares. More capital will become available because, in addition to domestic investors, foreign investors – particularly institutional – will be interested.”
“Locally listed companies compete with their peers for capital and the companies that can convince investors best – which ties in with corporate governance – are more likely to be in a competitive position to attract capital. This is important to us as investors. We like to see corporate governance improve, because it creates value for us as minority shareholders.”
Co-Head of Robeco’s Sustainable Global Equity team and head of the Fundamental Equity CPM team
Opening up of the A-share market leads to increased institutional flows.
How sensitive is the A-share market to economic reforms in China? And the trade war?
“The reforms and longer-term reform themes are going to be important drivers for the Chinese market. There are many examples of policies that impact market performance, such as the cut in the VAT, which supports the private sector. And, yes, the trade war is affecting local sentiment. There is definitely awareness in China of the ongoing trade tensions. There is more awareness now of what is happening internationally than five or ten years ago.”
“So, the trade war is dampening sentiment which was illustrated in May and in August, when after a strong run in the first few months of the year, an escalation of the tensions rattled Chinese equity markets, including A-shares. The trade war is also having a direct impact on the economy and businesses, in particular exporters and technology firms. So the measures are definitely impacting the Chinese economy to some extent, but it is important to note that the large majority of exporters are not listed on the stock exchange.”
Is buying A-shares based simply on their inclusion in the MSCI EM a good idea or should you have another strategy in place?
“That is a good question for an active investor. In our view, it’s never a good idea to buy a stock just because it is included in an index. We have a concentrated, high-conviction portfolio and the index just does not matter that much. So, as an active investor, our focus is on the fundamentals of stocks and on the price we pay for the expected earnings – particularly in relation to the cost of capital. And that has nothing to do with inclusion in any index.”
The A-share market is considered to be dominated by local retail investors and, therefore, more volatile. Do you expect this to change?
“It is still dominated by local retail investors. Retail is responsible for about 80% of the trading volume and while I definitely expect this to change, the process will be gradual. As the market matures and China opens up, it will attract more international institutional investors. This group is much more aware of the cost of trading and, generally, more long-term oriented. They also have a much greater interest in corporate governance, which means that the market – and management teams – will inevitably change.”
China traditionally likes to have control over companies, the economy and the stock market. What does that mean for investors in A-shares?
“This does affect the A-share market, and investors have to be aware of the uncertainties they face. The Chinese authorities have introduced many meaningful and effective measures in recent years. Yet we have also seen measures that have had a temporary adverse effect on the market. An example is the circuit breakers that were introduced a few years ago. Aimed at triggering a timeout from trading to stop prices tumbling, these had the opposite effect, feeding panic selling and sending the markets into a tailspin. I think it is good to be aware of all of this and the fact that China is still in the development phase, so shocks are to be expected at times.”
“But when it comes to stabilizing the economy in the periods of growth slowdown, infrastructure spending and measures to support the real estate market have proven really effective over the past decade. We expect this year’s consumption and infrastructure spending to also provide support to overall economic growth.”
Corporate governance stands to improve.
Leverage, in other words debt, is often considered an issue in China. How does that affect listed companies in the local market?
“What draws the most attention is China’s overall debt position, which has ballooned in the aftermath of the global financial crisis. That debt mostly sits with the state-owned enterprises; China has relatively little household or government debt. The government has made some progress in the management of that debt, which compared to other large markets is not particularly high. It is on the high side though, and therefore it should be monitored.”
“It would be tough to say how total debt levels affect individual companies, but the quality of companies’ balance sheet and their ability to manage it are an important ingredient of our analysis.”
“Also, the opportunity cost for investors of avoiding a certain equity market based purely on its total debt position can be very high, as history has proven. For example, the Chinese equity market generated a return of over 50% in 2017. If you would have avoided this market based on total debt position, you would have severely missed out.”
Would you say the A-share market is more diversified than the offshore market?
“Yes, it certainly is versus the offshore market (Chinese stocks listed in Hong Kong and in the US). A-shares is a much larger market. There are many sectors and subsectors that account for over 80% of the total industry exposure in China. An example is the industrial sector. A very large majority of industrial sector stocks are listed onshore, in the A-share market. For us, the industrial upgrading of China constitutes an important theme – through which we are naturally directed to the A-share market.”
What about volatility, currency, liquidity, valuations, lack of transparency and the other risks associated with the A-share market?
“There is definitely some risk associated with lower levels of transparency. This links to corporate governance which needs to develop further.”
“As for volatility, most of this comes from natural factors that are present in every market, but the relatively large retail investor base and some unpredictability surrounding government measures may amplify volatility at times. Yet, the same thing is currently happening in developed markets – like the US, where the market is shaken up regularly by the acts of a powerful leader who is now known to be unpredictable.”
“Although some degree of currency depreciation might occasionally occur as a defensive response in the trade dispute, I don’t believe significant currency weakening is very likely as China has quite an interest in maintaining a stable currency. We think that Chinese authorities will be more inclined to use other measures to stimulate the economy, such as the VAT cut and infrastructure investments I mentioned earlier.”
“Liquidity is not a risk, really. The market is very broad, very deep and liquid, and stock suspension levels have come down considerably. We mostly limit ourselves to larger stocks. Out of roughly 4,000 stocks in total, there is a pool of 500 highly liquid ones. So, liquidity is no more of a risk than in other markets.”
Does taking a quantitative approach make sense?
“We do have a quant strategy and our research shows that quant models do well and provide good returns too. It is a matter of taste – what an investor is most comfortable with. We find the approaches to generally be complementary. So a mix of the two can be a good way to go.”