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China Small Caps: The World’s Growth Engine?

From the May 2019 Thought Leadership China Report

Over the past four years, China has made significant efforts to further open its capital markets, and in February, index provider MSCI announced its decision to increase the weighting and breadth of China A-shares exposure in its emerging markets index, as well as in its China index and other regional indices. The three-step implementation process will see  the inclusion factor go from 5% to 20% in total by November 2019.

These increases are naturally of great interest to investors but to a large extent, merely scratch the surface of opportunity in the latest iteration of China’s growth story. 

1 Why a Dedicated Allocation to China Makes Sense

Capturing the growth of the world’s second-largest economy, China equities can serve as a core, strategic holding for long-term investors. Yet many investors remain under-allocated, despite China’s enormous economic output. China currently makes up roughly 33% of the MSCI Emerging Markets (EM) Index, so some investors may think they have adequate China exposure through their EM allocation. Investors often allocate less than 10% of an overall portfolio, however, to emerging markets. Against this backdrop, China may represent only 1% to 3% of a portfolio that is considered to be globally diversified. What’s more, many active EM managers are underweight China relative to the benchmark, so investors might have even less exposure to China than they intend. Given that the size of China’s economy could surpass that of the U.S. within a decade, many investors may need to increase their weight toward China to better align portfolios with long-term goals. 

Where to Invest in China: New Sectors Drive Earnings Growth 

The earnings story in China today is about changing market composition. The old industrials are becoming less important while the new industrials are taking on a bigger role from a macro perspective. As bottom-up, fundamental investors, at Matthews Asia, we see the emergence of sectors such as IT, pharmaceuticals and consumer discretionary. The composition change is important for the earnings turn, and we believe earnings are on more solid footing than in previous cycles. Earlier, we saw the earnings cycle in China as cyclical in nature – now, in part due to consumer spending, we are beginning to see less cyclicality in the cycle. 

We believe a dedicated allocation to China can help investors fine-tune and recalibrate how they gain access to the world’s fastest-growing economy, while improving global diversification. As a core portfolio holding, China equities can comfortably sit alongside such portfolio staples as U.S. and EAFE (Europe, Australasia and the Far East) investment strategies. Looking ahead, we expect earnings growth in China to be increasingly driven by innovation and consumer-driven sectors. As the spending power of China’s middle class continues to grow, sectors and industries such as health care, travel and leisure, and consumer services will play a much greater role in fueling China’s economic engine. Accordingly, we believe that an effective way to capture the future of China’s growth is through a dedicated allocation to China that employs an active approach to security selection. Given China’s growth potential, investors may benefit from considering China strategies that are forward-looking by design, seeking to capture China’s future, rather than its past.

2 The Strongest Dividend Story in Asia

Investors typically focus on China’s growth that is driven by structural changes, middle-class consumption, and the country’s move up the technology value chain. But the income story is equally important, says Sherwood Zhang, CFA, portfolio manager of the Matthews China Dividend strategy. Dividends also are a way to combat market volatility.

“It is often forgotten that China is the strongest dividend story in Asia,” Zhang says. “H-share payouts have multiplied by a factor of 14 in the past 20 years.” 

Chinese companies paid out just $8 billion in dividends in 1998. By 2017, that figure had risen to $114 billion.

Across Asia, many listed companies are aligning their dividend strategies more closely with shareholder needs, aware that a strong and sustainable payout reflects good underlying capital allocation by company management. Chinese businesses are no different and have led the dividend revolution in the past 10 years. Annualized dividend growth was 14.6% in the decade ending 2017, significantly ahead of South Korea (8.6%) and the rapidly emerging economies of Thailand (7.5%), Indonesia (10.2%) and the Philippines (7.8%).

Matthews Asia has significant experience investing in dividend-paying companies in Asia for over 25 years. 

“We run a balanced portfolio of stocks that collect dividends from companies from various sectors, industries and market capitalizations to ensure both stability and long-term growth in dividends,” Zhang says.

The dividend lens

To ascertain the ability of a company to pay growing dividends, Zhang and his team start with fundamentals. They seek companies with strong financials, solid balance sheets, low financial leverage, and improving cash flows and dividend payout ratios.

“Dividends are a lens through which we identify high-quality, financially healthy companies with prudent capital allocation policies,” Zhang says.

Zhang notes that dividends can be a better indicator of business performance than reported accounting growth. A corporate commitment to dividends is an incentive to management to be highly disciplined in the returns they generate on capital invested.

Outlook for dividend growth

Zhang believes Chinese companies will continue to deliver low-teens earnings growth over next two years and that dividend growth should at least be in line. He thinks some of SOEs (state-owned enterprises) might even raise their payout ratio this year to generate revenue to offset the Chinese government’s aggressive tax cut. 

3 China Small Caps: The World’s Growth Engine?

With the idea of a dedicated allocation to China receiving more and more consideration from institutional investors globally, many are drilling deeper into the type of exposure they have, going beyond adding China for its own sake and looking for more growth opportunities. As they look for differentiation with respect to their China holdings, China small entrepreneurial companies – which now constitute the world’s largest small cap market – are emerging as powerful engines of growth.

4 China A-Shares: A More Rational Market Emerges

In the ceaseless search for alpha, global investors are taking notice of many trends in China, but two of the most important are that the earnings for A-share companies is strong and expected to remain so, and that valuations of A-shares are now more in line with offshore Chinese equities. For a glimpse at what is driving these trends, II spoke to Richard Gao, Portfolio Manager and Research Principal, China, Matthews Asia. 

How has the inclusion of China A-shares in MSCI’s emerging market indices played out for foreign investors so far? 

Richard Gao: Right now, we are very excited about the A-share market in terms of the valuation. It is trading at a very attractive PE ratio compared to its historical average. Historically the A-shares are known for their volatility and high valuations. Interestingly, Chinese companies listed offshore had been trading at a much cheaper valuations because the A-share market is dominated by retail investors, and retail investor behavior tends to be more speculative, news-driven, and short-term oriented. Historically, that’s why volatility and valuations were high. 

How is increased participation by institutional investors affecting the investment culture in China? 

Gao: The valuation gap between onshore and offshore Chinese companies has started to narrow over the past two years because investors are becoming more mature and influenced by the growing participation of institutional investors – especially foreign institutional investors. At the current level, we can see that China A-shares are trading at similar valuations compared to offshore equities without much premium. I’ve been following the A-share market for more than a decade, and there were very few times when I’ve seen A-shares trading at such low valuations – and with no premium over the offshore listed equities. This is really an interesting time to look more into the A-share  market.

Specifically, regarding foreign institutional investors, what has been the effect of their participation in A-shares? 

Gao: Foreign institutions’ participation in the A-share market has increased quite substantially. Over the past three years, the foreign  ownership of A-shares increased from less than 1% to close to 3% now. We expect this trend to continue in the coming years, and the growing participation of the foreign institutional investors to have positive impact on the investment culture and investors’ behavior in China by shifting the focus to the long-term fundamentals of companies – a more rational approach. At Matthews Asia, we are very excited to see this trend happening because it is right in line with our long-term fundamental approach when it comes to picking stocks.

Does passive participation in the index necessarily access the best opportunities in China? 

Gao: Most participation in A-shares from foreign institutional investors is passive investment –they pretty much follow MSCI’s guidance. But if we take a close at China A-share inclusion in the index, you’ll see that the components are quite concentrated in areas such as financials and industrials. There is much less exposure in the new economic sectors – health care, information technology, consumer discretionary, and consumer staples combined only account for about 33% of the index. We don’t believe this to be a very good representation of investment opportunities in China, especially in the newer and more dynamic areas of the economy. Of course, MSCI has its own selection criteria, which includes market capitalization and liquidity, but we believe that our active investment approach will lead to more growth opportunities among much smaller companies within the domestic consumption and services sectors, for example. And we think that will drive China’s future growth.

5 The World’s Cheapest Stimulus

Andy Rothman is an investment strategist at Matthews Asia, and lived and worked in China for more than 20 years, analyzing the country’s economic and political environment, before joining the firm in 2014. As an investment strategist, he has a leading role in shaping and presenting Matthews Asia’s thoughts on how China should be viewed at the country, regional, and global level. Here he shares his recent thoughts on steps the Chinese government has taken to strengthen investor sentiment. 

With just a modest boost to credit, the Chinese government succeeded in strengthening investor sentiment and stabilizing real economic activity during the first quarter of the year. The growth rates of income, retail sales and industrial production were stronger than in the fourth quarter of last year, without a dramatic stimulus. The central bank has signaled that it is comfortable with growth prospects for the coming quarters and wary of unnecessarily raising the national debt burden, so any additional stimulus will likely be even more modest.

In my view, the biggest weakness in China last year was poor sentiment among the country's entrepreneurs and investors, despite reasonably healthy macro activity and strong corporate earnings growth. This provided the government with an opportunity to take several inexpensive steps to boost sentiment.

As expected, the state-controlled banking system increased credit flow during the first quarter, but – also as expected – the increase was modest. The growth rate of outstanding augmented total social finance (TSF), the most comprehensive metric for credit in the economy, accelerated to 11.3% year-over-year (YoY) in March 2019, up from 10.8% in February and the first month over 11% growth since September 2018. But, to put this into context, the 11.3% pace in March was slower than the 12.6% pace in March 2018; the 14.6% in March 2017 and 16.6% in March 2016.

Another way to illustrate the modest scope of the credit stimulus is to look at the gap between the growth rate of augmented TSF and the growth rate of nominal GDP. In the first quarter of 2019, the gap between the growth rate of credit and of nominal GDP was 3.5 percentage points (pps), roughly the same as the 2.3 pps gap in Q1 2018, and significantly smaller than the 9.7 pps gap in Q1 2016. To put this into further context, in 2009, as Beijing was responding to the Global Financial Crisis, the gap was 26.8 pps.

It is also worth noting that the government has not abandoned its financial sector de-risking campaign. Off-balance sheet, or shadow credit, declined 10.3% YoY in March, compared to increases of 5.5% in March 2018 and 11.5% in March 2017. 

Beijing also refrained from turning on its traditional public infrastructure stimulus taps. Infrastructure investment rose only 4.4% in the first quarter, compared to 5% in Q4 2018 and 13% in Q1 2018.

See more from Andy Rothman on further steps the Chinese government took to strengthen investor sentiment, and what the effects of the effort have been. 

The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Past performance is no guarantee of future results. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. The information contained herein has been derived from several sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information. This report is for informational purposes and is not a solicitation, offer or recommendation of any security, investment management service or advisory service.

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