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China: about quality, not quantity, these days

Global stock markets recently witnessed a major milestone: Chinese A-shares1 – 226 of them – were added to global index provider MSCI’s widely-tracked benchmarks for the first time. It’s been the talk of the industry.

For now it’s a drop in the ocean; there are more than 3,500 A-shares in all with a combined market capitalisation of US$8.5 trillion. The initial inclusion of A-shares will account for less than 1% of both the MSCI Asia ex-Japan Index and the MSCI Emerging Markets Index.

It means that A-shares are going to be increasingly difficult for international investors to ignore.

But inevitably this will increase over time as China continues to open up its domestic capital markets. It means that A-shares are going to be increasingly difficult for international investors to ignore. This is a large and liquid market, after all, with many varied sectors to invest in.

That’s not to say that finding good stocks to buy in mainland China is easy. It isn’t, and we have been scouring the market for more than a decade.

Corporate governance standards remain poor on the whole. Companies have much ground to make up in terms of financial transparency and investor protection. Independent directors are few, board accountability is often lacking and minority shareholder interests are largely overlooked.

It underlines the importance of performing proper due diligence before you invest. Many A-share companies are relatively young, with too short an operating history for us to gain comfort in their track record. That’s why this a stock-picker’s market.

What we find encouraging about MSCI inclusion is that it promises to raise currently minuscule foreign participation in the A-share market, exposing local managements to global standards of accountability. The hope is it will foster a longer-term, institutional investment mind-set.

But MSCI inclusion has no practical application for us as a stock-picker. It doesn’t affect our view of whether a company is good or bad, nor do we feel any need to adjust our portfolios. We take a long-term view of what has historically been a volatile and momentum-driven market. It is important to carefully scrutinise company fundamentals and valuations before investing.

The real significance of MSCI inclusion is what it says about China’s financial evolution. Yes, authorities will make missteps along the way. The 2015 equity market crash is a case in point, when nearly half of the stock market was suspended from trading as nearly $3 trillion was wiped from share values in three weeks. Learning lessons from this is what’s important.

For now, there aren’t many companies that meet the standards we would expect before we commit our clients’ money. Our comfort with A-shares will grow as more companies confer rights of ownership on outside shareholders. That said, there’s still quality in the market. In particular, stocks in sectors such as consumer, travel, wealth management and healthcare could potentially be well placed to benefit from China’s rising middle income wealth.

As an investor we won’t stop asking difficult questions. I wouldn’t have it any other way. But it’s equally important to remain open to the opportunities that China’s opening presents.

 

1 A-shares: A-shares are ‘onshore’ shares in mainland China-based companies that trade on the Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange.

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