In spite of the compelling growth trajectory of the Chinese economy, the expansion of its middle class, and the size of its local capital market, the performance of China’s equity market has been mixed and highly volatile in recent years. Having surged 60 percent in the first six months of 2015, but given up most of these gains in the second half of the year, the benchmark Shanghai Composite Index was one of the poorest performers in 2016, falling by over 12 percent.
The dizzying volatility of Chinese equities is attributable to a number of factors. One is that the universe of quoted stocks is an inaccurate proxy for the economy. Another is that although the combined market capitalization of the Shanghai and Shenzhen Stock Exchanges make China the world’s second largest equity market, the overwhelming influence of retail investors has historically made the market highly inefficient.
This is changing in line with an increase in the institutional share of ownership as well as trading volumes in China. This process, which has already accelerated through the Stock Connect initiative, is expected to gather momentum following the inclusion by MSCI of Chinese ‘A’-shares in its Emerging Markets Index as from the summer of 2018.
Plenty of challenges still need to be tackled by the Chinese authorities in reforming and modernizing its equity market, including changing the T+1 settlement rule, addressing shortcomings such as stock suspensions and short-selling constraints, and addressing the restrictive daily quotas on foreign participation. But China is clearly becoming a more institutional market.
This means that for investors looking to unlock the potential of equity investment in the world’s second largest economy, understanding market nuances will become increasingly important. So too will the analysis of how economic regimes will create timing opportunities for investors.
Measuring stock selection signals in China
S&P has developed several research products designed to help investors identify these opportunities. These include the alpha factory library, which tracks hundreds of stock selection signals in the China ‘A’-share market. Given that most of the 222 stocks due to be included in the MSCI benchmark are large caps, the agency selected the S&P ‘A’-Share 300 as a proxy for tracking the performance of various strategies over time.
Kirk Wang, Head of Quantamental Solutions, S&P Global Market Intelligence, explains that these strategies are generally based on four main themes – sentiment, valuation, quality, and risk – which between them measure eight style categories. Price momentum and analysts’ expectations measure market and sell-side sentiment, while valuation tracks traditional value and growth. Quality, meanwhile, evaluates capital efficiency and earnings quality, while size and volatility gauge fundamental and technical risk.
The conclusions drawn from a historical analysis of these styles, each of which represents a type of systematic market bias and investor preference, is that since 2005 the best-performing style portfolio has been analysts’ expectations. “This indicates that the market rewards stocks that are favored by the sell-side,” says Wang. “Valuation and growth have also been successful styles, suggesting that stocks that are regarded as cheap or offering growth potential also outperform. Earnings quality and capital efficiency, meanwhile, have been less powerful drivers of performance.”
While these historical yardsticks can provide instructive pointers on the main influences on stock performance, the substantial flows of foreign money expected to be channelled into the market following index inclusion means that foreign ownership levels will also be an increasingly decisive factor going forward. This can play a constructive role in understanding the crowdedness of trades, and running rank correlations between the foreign ownership level and other stock selection signals.
Wang says that this generates some interesting relationships, such as the strong positive correlations between foreign ownership, valuation, and capital efficiency, and the relatively negative correlation between overseas participation and company size. The conclusion is that foreigners tend to focus more than domestic investors on large cap value and quality stocks.
Given the emphasis that foreign investors place on value, S&P Global Market Intelligence has undertaken a deeper analysis of the correlations between value and other strategies. Its conclusion is that there are strong positive correlations between value and quality, and between value and growth, while there is a conspicuous negative correlation between value and size. “This implies that investors overweighting value stocks in China are betting against smaller caps, which means that any run-up in these stocks is likely to have a negative impact on their value strategy,” says Wang.
The impact of economic regimes
Another important tool for generating alpha in China is the identification of certain economic, market, and regulatory conditions that may have an impact on the market, and an assessment of the probable impact of each of these influences on equity valuations.
Given widespread concern about the potential for an economic slowdown in China, following annual GDP growth of at least 7 to 8 percent since the early 1990s, many investors are asking how they should position themselves in advance of a hard or soft landing. One prism through which this can be analysed is the Purchasing Managers’ Index (PMI), which is standardized and comparable across time.
Research by S&P Global Market Intelligence on the correlations between this indicator and the China-300 style performance finds that when PMI picks up, size and volatility work, while quality does not, suggesting that investors risk appetite rises. When PMI declines, the opposite effect is observed, with investors becoming more risk averse, according to S&P Global Market Intelligence.
Extrapolating all these indicators to identify short-term opportunities suggests that Chinese ‘A’-shares are expensive relative to those in the MSCI Emerging Market (EM) Index, with China continuing to trade at a significant price premium to other markets. For the time being, says Wang, this implies that on the basis of dividend yields, valuations in the ‘H’-share market currently look more compelling than those in mainland ‘A’-shares.