How to build an A-list out of (China) A-shares
Author: Regina Chi
August 7, 2018
The inclusion of Chinese A-shares to MSCI’s various indices is a landmark event that opens up the world’s second largest stock market to a growing number of global investors. But the opportunities to buy stocks listed on China’s mainland exchanges will remain limited over the next few years and it will take time before they become a more significant part of our diversified strategies focused on the developing world.
Starting this past June and continuing in September, MSCI plans to add 233 shares out of an approximate 3,500 names that are presently listed on both the Shanghai and Shenzhen domestic markets. This will represent just less than 1% of the global indexer’s emerging market benchmark, with greater weightings happening over time and eventually leading to full inclusion of the A-Shares market some eight to ten years from now.
The A-shares being chosen for inclusion this year are predominantly large and mega capitalization stocks with high earnings and dividend yield(s), low volatility and low beta. More mid-to-small cap names will likely be added over time to better reflect the overall size characteristics of China’s domestic market, but MSCI said it still has a number of considerations to make in its inclusionary process going forward.
Namely, it wants to see greater alignment of the A shares market with international market accessibility standards, as well as relaxation of daily trading limits, continued progress on trading suspensions, and further loosening of restrictions on the creation of index-linked investment vehicles.
Given this gradual road map to full inclusion, investors will need to carefully weigh the characteristics of the A-shares market and potential advantages of its listed companies against the backdrop of a much vaster pool of opportunities in other emerging markets.
For starters, the Shanghai and Shenzhen exchanges include many unique sectors that are not easily accessible through offshore listed equities (i.e. traditional Chinese medicine) and combined have a greater weighting in industrials, consumer goods, basic materials and health care stocks than the Hong Kong (H-shares) market. At the same time, A-shares may be a better way to gain exposure to China’s faster-growing new economy.
From a diversification standpoint, A-shares have also been less correlated to global equities than H-shares historically and for active investors, the dispersion of its returns is significantly higher than many other global markets, according to UBS research.
Offsetting these benefits, perhaps, is the fact that A-shares are typically lower yielding than other global markets. Certain behavioural aspects of the A-shares market, meanwhile, can lead to a much different trading experience than usual for many global investors who are new to the market.
Of note, retail participation in China accounted for 85.6% of the total A-shares trading volume in 2016, according to a survey published by Shanghai Stock Exchange last year. This lack of institutional involvement can lead to pricing inefficiencies and has tended to coincide with a general preference for small cap and/or momentum stocks that are more volatile than their larger, blue chip counterparts.
While the various facets of China’s A-shares market can help diversify an investor’s portfolio, this must always go hand-in-hand with a thorough analysis of the individual companies being considered.
In this regard, the AGF global equity team’s criteria for adding A-shares is no different than it is for all the other investable names in the universe. We expect companies to generate a high cash flow return on investment (CFROI) and want our buy candidates to have at least 15% appreciation potential over the next 12-18 months.
Currently, we have identified several interesting A-shares opportunities, but lofty valuations have prevented us from buying in just yet. When we do, our exposure will likely remain minimal as we wait patiently for more opportunities to unfold over time.
Regina Chi is a vice president and portfolio manager at AGF Investments Inc. She is a regular contributor to AGF Perspectives.