China’s A shares: Ready for their MSCI debut
On 1 June, China’s A shares made their MSCI debut. Investors have been waiting a long time, but finally as many as 234 of the yuan-quoted shares of mainland Chinese companies have been included in Morgan Stanley Capital International’s (MSCI’s) global and regional indexes.
Listed in either Shanghai or Shenzhen, the shares will be added in two phases: one in June and one in September.1 While these are baby steps for China’s financial community, it has taken five years and four rounds of MSCI discussions with global investors to get to this point.2
And it’s a long journey of opportunities ahead for global investors as these 234 predominantly large-cap stocks are a mere drop in the ocean. The entire A-share market is one of the biggest in the world, comprising 3,500 stocks that together are worth around US$8.5 trillion.3
The initial index inclusion will comprise only about 0.9% of the MSCI Asia ex Japan Index and 0.8% of the MSCI Emerging Markets Index. The allocation could potentially rise to between 14% and 18% over time.
With over US$1.9 trillion in assets benchmarked to the MSCI Emerging Markets Index,4 funds that track the index will have to allocate about US$15 billion to A shares after September to avoid deviation. This inflow will hardly move the needle, given the overall free float of US$3.4 trillion and the daily turnover of US$75 billion.5 Still, the MSCI inclusion shows how far China has progressed in its capital market reforms—specifically, on internationalizing the yuan and linking its exchanges to the rest of the world.
Bulls and bears
According to conventional wisdom, investing in emerging markets is a risky venture and China is no exception.
Over the past decades, Chinese capital markets have seen their share of bulls and bears, culminating with a boom and bust in 2015 that wiped US$3 trillion off the value of mainland shares in three weeks. Retail investors, emboldened by margin lending, had aggressively chased shares before the inevitable, painful moment when the bubble burst. Government intervention was heavy-handed and at times ill-conceived. Nearly half of the domestic-listed companies were suspended from trading.
As international investors in China, we believe in the importance of taking the bull by the horns. Good corporate governance, balance-sheet strength, an easily defendable competitive advantage and respect for minority shareholders are core principles when investing in China, as they are in any market.
So, notwithstanding the MSCI inclusion, nothing has changed when investing in mainland Chinese companies. Investors need to understand the nuts and bolts of a business to assess its quality and fundamentals. They also need to conduct due diligence on management and pay careful attention to valuations to ensure they pay a reasonably fair price.
Consumption, consumption and consumption
More broadly, the A-share market has the widest choice of mainland Chinese companies, including quality companies in unique sectors, such as traditional Chinese medicine. Such sectors aren’t common in offshore markets, and some of the companies have the potential to be market leaders, not only domestically but globally. Admittedly, the dispersion of returns among A shares is also much higher than many other markets elsewhere, but for the discerning investor, it can mean reaping handsome gains. Furthermore, the A-share market has historically been less correlated to global equities than H shares (which are shares of Chinese mainland companies that are listed on the Hong Kong Stock Exchange or other foreign exchanges), offering diversification benefits to institutional investors.
China’s consumption of anything and everything is certainly one of the most-watched trends among investors in emerging markets. Companies that can benefit from growing domestic consumption have fared well. For example, travel-related businesses and makers of smart appliances offer good access to the growing middle class and the pursuit of quality. The insurance and healthcare industries are set to benefit from an aging population and an increasing desire for a healthier and better-quality lifestyle.
In our view, there are about 30 A-share companies that have established a strong foothold in their industries and taken steps to adopt international management practices. This may seem like slim pickings to some, but if China continues to commit to stock and capital market liberalization, investors are unlikely to be kept waiting too long for quality to improve and more investable companies to surface.
- MSCI Equity Indexes May 2018 Index Review, MSCI, May 14, 2018.
- What is China's A-share MSCI inclusion? The Business Times Online, May 15, 2018.
- China A Shares – Get Connected, UBS, May 14, 2018.
- MSCI data as of March 31, 2018.
- What can we expect from MSCI A-share inclusion, UBS, May 14, 2018.
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