China – Too big and inefficient to ignore

Since China joined the WTO in 2001, and opened up its economy, it has experienced strong growth over the last decade. China’s GDP is now the second largest in the world, and it is anticipated to grow at a rate between 6 – 7% over the next 5 – 10 years. It has become one of the most influential markets in the world.

The fast growing economy also breeds a large financial market. Currently, the Chinese listed equity market is the second largest in the world, and it is anticipated to grow much bigger in the future. Across the global exchanges, there are more than 4,000 Chinese listed companies. The breadth and depth of this market presents a great investment opportunity.

In China, the company needs to be approved by the regulator before it starts its IPO process. Every year there are about 600 companies in the pipeline who are waiting to be approved and listed on the onshore ‘A share market’. This suggests the investment universe is still transitioning to be bigger and broader.

As of today, China’s onshore equity market is not part of the MSCI global index, however the index provider is close to making the decision regarding inclusion of China A stocks. At full inclusion, China represents about 40 – 50% of the EM index, which could represent 6 – 10% of the ACWI index. The potential flow into Chinese onshore equities could be material.

Apart from its sheer size, the China onshore market is probably the most inefficient market ever seen in the global capital market. A few forces are behind this phenomenon.

In China, approximately, 85% of the market participation is retail investment. Being a typical retail driven market, this market is very often mispriced which offers more room for alpha generation, for long term fundamental minded institutional investor.

More interestingly, the stock market participation rate is about 9% of the population in China (source SWUFE). And stock is only 15% of average householder’s financial asset and we all know Chinese community likes to save (about 60% saving rate).

As result, this high retail participation rate is going to stay in the market, which drives the market away from its fundamental fair level.

The market inefficiency can also attribute to the limited coverage by the broker and sell side analyst. There are more than 4,000 stocks listed which about 3,000 are in the China onshore market. Roughly, the analyst coverage of the stock is very limited. The banning of short selling in China also amplifies it as the analysts have limited incentive to issue negative ratings, thus the research fails to reflect the fundamental risk.

In China, the institutional investor is a small part of the market, the lack of knowledge and stock assessment skill of the non institutional investors makes it one of most inefficient markets. Particularly, the foreign investor is about 2.5% of the market. Also the language barrier is another limitation for foreign professional investors to exercise the stock selection skillset, another typical example of information asymmetry.

The history has shown the intra-sector return dispersion is tremendously high, as shown in two charts below. The China A share intra-sector return is materially higher than equivalent US equity.

The dispersion also implies another interesting point: growing divergence. As we stand here outside China, we normally generalise things for China by assessing the headline number e.g. GDP. With the ongoing profound transition of Chinese economy, the headline aggregate number becomes less important for equity investment because the economy size is so big and complex in structure, and more importantly, the great divergence is happening for different sectors.

One profound evident represented with China CSI300 index (a common equity index for China). Over the last six years, it was almost flat, but the sector performance shown in the below bar chart diverged tremendously.

Overall, China is a very interesting and dynamic market, we are going to discuss a series of hot issues, with a focus on listed equity markets over a few articles.  So please keep an eye out for our China series.

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