China’s onshore equities, commonly known as “A-shares,” represent a significant opportunity for investors, despite recent challenges. These RMB-denominated securities, which trade on China’s domestic stock exchanges and are tracked by MSCI, have underperformed global markets over the past three years, ending September 30th, 2024. During this period, MSCI China A shares declined by 7.9% annually, while the MSCI ACWI gained 8.7% per year. However, despite this underperformance, the long-term perspective is more promising. Over the past 20 years, MSCI China A index has achieved an annualized return of 7.5%, a performance that remains competitive with MSCI ACWI’s 9.1%, which has been heavily influenced by the U.S. market’s growth (refer to Figure 1 above).
There are many reasons accounting for China’s under-performance: from the government’s excessively tight Covid policies since 2020, a crackdown on the tech sector, to the debt overhang in the property sector and falling real estate prices. This is further exacerbated by challenging demographics and rising geopolitical risks.
Why invest in A-shares now? We feel there are four key factors that are under-appreciated by investors.
1. China A shares are trading at a significant discount relative to its own history. This discount level has historically pointed to strong forward returns
2. China A shares offer high and increasing diversification benefits to global investors
3. Bolder policy support is underway to stimulate the economy and importantly encourage better capital allocation by companies, of which dividends and share buybacks are increasingly important
4. China A shares offer great scope for stock selection and alpha generation given the inefficiency of the asset class
China A-Shares are significantly under-valued
As of 3Q 2024, China A shares are trading at a trailing P/B of 1.6, at a significant >1 standard deviation below its historical 10-year average. Historically, this level of valuation has acted as a floor to further sustained downside. Objective historic return analysis undertaken by us indicates that buying when the index is below normal range levels (at greater than 1 standard deviation below its mean) would have generated annualized returns of 22% in the 3-year period ahead (more details in Table 1).
Another important by-product of China A shares’ underperformance has been the decoupling of the asset class’ correlation with global markets. Whilst China equities have historically demonstrated amongst the lowest correlations to global markets, this has become even more pronounced in the most recent 3 years as illustrated by Figure 2.
China A-Shares offer substantial diversification benefits
Within China, MSCI China A shares exhibit even lower correlation to global markets compared to MSCI China. MSCI China index excludes the large index weights of foreign currency denominated internet names, which also feature heavily in the EM index. As a result, A shares offer a broader and much more diverse exposure to industries and companies across China, of which a tiny 2.9% is included in MSCI ACWI1 given low index inclusion factor to China A shares to date.
China A Shares: To provide higher returns through dividends and share buybacks
The weak performance of the broad economy and stock markets have not escaped the attention of policy makers in Beijing. Policy makers are increasingly turning their focus to a more sustainable form of value creation, shifting corporate China‘s focus away from traditional metrics of growth and high levels of investments towards profitability and return on invested capital to shareholders.
Policies targeting state-owned enterprises (SOEs) began as early as November 2022 when China’s securities regulator, the CSRC, shifted the assessment framework for SOEs from revenue growth targets to profitability and cash-generation metrics, including ROE, cash conversion, and dividends. This has been followed by the State Council’s Nine-Point Guideline plan introduced in April 2024. The plan introduced policies to encourage higher dividend payments and improve shareholder rights for the broader market. We are already seeing this take effect as the dividend pay-out ratio at the index level for MSCI China A is estimated to rise to 37% for 20243, from an average of 30% in the past decade, according to FactSet data. We believe that dividend pay-outs will continue to rise in the years ahead. Relative to the 47% pay out offered by MSCI EM excluding China, there is significant scope for A-Share companies to raise the pay-out ratio further and for dividends to outgrow earnings over the years to come.
Very recently in September, the PBOC announced a sizable funding package of lending to institutions to invest in Chinese equities, and to companies to buyback their own shares. Indications are that further fiscal support towards consumers would be forthcoming, underscoring the government’s concern for the economy and stock market.
For the average Chinese household, most of the wealth has traditionally been invested in the property market given the closed capital system adopted by China. Within such a closed system, there is significant scope for more allocation to equities, particularly if the outlook for real estate prices remains challenging. This would be in line with the government objective of fostering a viable self-funded pension system that can present an alternative to the property market and reduce the government’s own fiscal burden. If over time, both companies and domestic investors adopt a long-term mindset that places greater emphasis on sustained dividend returns as opposed to short term share price moves, market volatility and risk premium may also decrease.
China A Shares: Meaningful alpha potential for active managers
Active managers possess significant scope to outperform due to the inefficient nature of the market. This inefficiency is driven by high levels of retail participation, insufficient research coverage, and an over-emphasis on short term trading. Over the last decade, the median active manager has outperformed MSCI China A by 4.7% per annum, a performance that the median manager in the MSCI World universe has struggled to match (see Figure 3).
In a market with over 6000 companies, stock selection opportunities are abundant (see Figure 4), with a breath of liquid opportunities across major sectors only second to the US market.
The potential for alpha generation appears set to continue. There is evidence that the new economic conditions in China will be a more favorable environment for disciplined value managers. They may be able to avoid the risks associated with the less price sensitive growth investing style which has historically dominated investing in China. Defensive and fundamentally driven value managers are also likely to protect capital in a market that is highly volatile. According to eVestment data, only 10% of China A share managers in their database, are categorized as Value managers. The same data also shows that the median Value manager has outperformed the broad benchmark by 9.7% per annum over the last 3 years, doing significantly better than their Growth and Core peers.4
Conclusion
In conclusion, we believe China A-shares offer a compelling proposition for institutional investors. With attractive valuations, low global market correlation and diverse opportunities, A-shares stand out as an attractive alternative strategic allocation for asset allocators.
History suggests that investing during the most pessimistic periods in China’s A share market tends to reward investors with high returns in subsequent periods. Notwithstanding the recently announced stimulus, China’s slowing economy indicate that the revenue and earnings trajectory are likely to moderate compared to history. We believe an important part of future returns for investors will be via dividends and share buybacks and there is ample opportunity for stock selection through active management. For example, Mondrian’s China A share portfolio trades on a P/E of 10x and has a starting dividend yield of 4.0%5, an attractive portfolio of focused holdings that also provide investors with an income cushion as China continues its economic transition.
Disclosures
Views expressed were current as of the date indicated, are subject to change, and may not reflect current views. All information is subject to change without notice. Views should not be considered a recommendation to buy, hold or sell any investment and should not be relied on as research or advice.
This document may include forward-looking statements. All statements other than statements of historical facts are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results to differ materially from those reflected in such forward-looking statements.
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eVestment Alliance, LLC and its affiliated entities (collectively, “eVestment”) collect information directly from investment management firms and other sources believed to be reliable, however, eVestment does not guarantee or warrant the accuracy, timeliness, or completeness of the information provided and is not responsible for any errors or omissions. Performance results may be provided with additional disclosures available on eVestment’s systems and other important considerations such as fees that may be applicable. Not for general distribution and limited distribution may only be made pursuant to client’s agreement terms. All categories not necessarily included, Totals may not equal 100%. Copyright 2012-2024 eVestment Alliance, LLC. All Rights Reserved.
This material is for informational purposes only and is not an offer or solicitation with respect to any securities. Any offer of securities can only be made by written offering materials. The information set forth herein is a summary only and does not set forth all of the risks associated with the investment strategy described herein.
The information was obtained from sources we believe to be reliable, but its accuracy is not guaranteed and it may be incomplete or condensed.
Unless otherwise stated, all returns are in USD
All references to index returns assume the reinvestment of dividends after the deduction of withholding tax and approximate the minimum possible re-investment, unless the index is specifically described as a “Gross” index
Past performance is not a guarantee of future results. An investment involves the risk of loss. The investment return and value of investments will fluctuate.
Dividend yield is not guaranteed and is subject to change.
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