The long march toward Chinese A-Shares

“As the second most important market in the world in terms of capitalisation, the A-shares market has become too important to ignore,” said Jean-Christophe Lermusiaux, vice-president and an emerging markets portfolio manager at Hexavest, in Montreal.

Too big to ignore, but harder to get

The total Chinese stock market combines the Shanghai and Shenzen Exchanges, which Christine Tan, assistant vice-president and emerging markets specialist at Sun Life Global Investments, in Toronto, likens respectively to the New York Stock Exchange and the NASDAQ. For the time being, individual investors still have access only through mutual funds and ETFs.

Until now, only three categories of Chinese stocks were accessible, in a very limited number of tickers, to foreign institutional investors: H-Shares, B-Shares and ADRs. The best known were ADRs, the vehicles through which investors could own pieces of international stars like Alibaba and Baidu mostly through the NYSE or the TSX.

B-Shares represent a limited set of Chinese stocks that trade in foreign currencies, whilst H-Shares are Chinese stocks regulated by Chinese law that are freely traded on the Hong-Kong Exchange in HK dollars. These B- And H-Shares numbered only a few hundred stocks; the A-Shares universe totals 3,600 companies, which compares to 2,800 on the NYSE and 3,300 on NASDAQ.

Still young, but growing fast

One must remember that the Chinese stock market is very young, and “opened only in 1990,” notes Tan. Past government decrees slowly pried it open to allow access to qualified foreign institutional investors. But the “real game changer”, as Tan highlights, is the Shanghai-Hong Kong Stock Connect of 2014, followed in 2016 by the Shenzen Connect, that allowed individual investors to purchase mainland Chinese stocks (in yuan) through their own brokers on the Hong Kong exchange.

In theory, individual Canadian investors should be able to purchase A-Shares through the Hong Kong stock market, but this doesn’t seem to be the case yet. “Our traders tell me that individuals can’t purchase A-Shares through Hong Kong, and we don’t really have any idea when it could be the case,” says Martin Bouliane, branch manager of Richardson GMP in Montreal. “Until further notice, individual investors need to buy through mutual funds or ETFs that invest in A-Shares.”

A key development is the increasing inclusion of A-Shares in two major indices, the MSCI Emerging Markets index and the MSCI All Country World index (ACWI). This initiative, started in 2018, is accelerating the influx of money from foreign institutional investors, points out Lermusiaux. By the end of April, the CSI 300 (the Chinese index composed of the 300 top A-Shares) had moved up by 34% since January, whilst the MSCI China index and the MSCI Emerging Markets had moved up by only 20% and 12% respectively.

In the course of 2019, MSCI scheduled to increase the weight of A-Shares from its present 0.8% portion to 4%, indicates Lermusiaux. If the index moves up to a full inclusion of A-Shares, China will hold a 16% portion, notes Tan.

Vast and diversified horizons

The attraction of A-Shares hinges on the potential diversification and growth they bring to an investor’s portfolio. Their sector breakdown is as varied as in the US, and includes industries such as banks (16%), health care (6%), chemical products (5%), transport and cars (7%), utilities (4%). Furthermore, the high technology component in the MSCI China index, which hovers anywhere between 35% and 40%, is larger than the S&P 500’s 30% share.

A-Shares form “a very attractive opportunity because of the type of companies that are now accessible, says Tan. You find in China some of the best consumer, health care and water treatment companies in the world. A lot of what we call the New China, other than Alibaba or Baidu, are now available through the A-Shares,” she observed.

Lermusiaux adds a different perspective. “Everyone talks about the ‘middle class’ theme in China, but what we really like are the qualitative changes and the rise in new consumption patterns that we track among those who are already part of the middle class. For example, you have people who invest in their own education, not only in their kids’, and who now buy Chinese prestige brands, not only international brands. These are things only the A-Shares can give us access to.”

What about the trade war?

The present U.S.-China commercial tensions and the weakening yuan don’t constitute an obstacle to investing for Lermusiaux. “One should distinguish between companies that export to the U.S., who are hit by increased trade tariffs, and domestic players who address internal needs. Sure, A-Shares are volatile and open to economic cycles and the feelings of local investors, but all the long-term trends we’ve identified remain real.”

Adds Julien Tousignant, an Hexavest economist: “China has sent a clear message that it doesn’t intend to lose control of its currency. We don’t think that it will abruptly devalue it; China’s lack of economic vigor calls for more stimulus, notably monetary. Maintaining very accommodating monetary conditions will exert downward pressure on the Chinese currency.”

Other climes, other risks

Venturing into this market is certainly not without risks. For one, investors need to be aware of a premium attached to stocks that have double listing as A-Shares and H-Shares. By May 13, the average premium was 23%. That involves 112 A-Shares, representing a third of total market capitalization. Lermusiaux believes this premium will tend to shrink as prices of A-Shares and B-Shares converge. “According to us, he points out, that represents a potential risk in the long-term holding of ETFs.”

Irregularities in reporting standards have haunted Chinese companies for a long time. They still do, but things are improving. As Tan indicates, the Chinese C-GAAP (Chinese Generally Agreed Accounting Principles) is 90% to 95% similar to IFRS standards that presently prevail in Canada, “so standards have really evolved, she says. Even US standards are only 90% IFRS-compatible”. Nevertheless, Tan, whose Sun Life Emerging Markets fund is slowly adding A-Shares exposure, remains wary. “There are thousands of accounting firms in China, but we look for companies that are working with the Big Four accounting firms (Deloitte, EY, KPMG, PwC). That way, you can get a better assurance of transparency.”

There is risk also in the simple fact that this market is very young – and huge. “There are many small and mid cap companies, and many are not experienced in the way of interacting with investors and have not been through a full economic cycle," adds Tan. "Analyst coverage is also very low. That spells risk, but opportunity as well. That’s why we recommend investors to go there through an experienced team,” she says.