The Chinese Equity Market Paradox

In just three decades China’s equity markets have evolved significantly from their humble origins in the 1990s. However, they still exhibit many of the structural deficiencies germane to emerging markets. Investors often attribute the excessive equity market volatility and inconsistent returns to a lack of understanding by Chinese retail investors as to the merits of long-term investing together with a dearth of broad institutional ownership that is typical in developed equity markets. And while speculation is indeed rampant among Chinese in- vestors, the fact remains that in a market that is now the second largest in the world, too few retail investors own stocks to make much of a difference in stock performance.

MarketGrader’s research shows that many of the problems that still plague China’s equity markets can be traced to the dual ownership structure promoted by the government in the early days of China’s privatization drive. This, coupled with strict capital controls that forced many of China’s most promising companies to list outside Mainland China’s exchanges, cre- ated an investment culture of insiders versus outsiders, where the insiders are the central and local governments who are still majority owners of almost half of all companies listed publicly in China’s domestic exchanges (SOEs). It is not a coincidence that these SOEs were the drivers of much of China’s industrialization program that made the country a manufac- turing powerhouse in less than four decades. They are the resource-heavy, old-line indus- trial companies in the materials, oil & gas, utilities and manufacturing sectors along with the state-owned banks that continue to fuel their growth with credit that is essentially backed by the state. Consequently, these SOEs grew in size to rival some of the largest companies in the world and as a result came to dominate the market cap-weighted indices that investors have used for years as benchmarks for China’s stock market.

There is, however, a newer crop of private companies in China that have grown alongside the SOEs segment of the country’s equity market. While not all are exclusively so-called ‘new economy’ companies, many of them are consumer-facing, service providers or high valued-added manufacturers in areas such as semiconductors, networking equipment and Internet infrastructure. In an era of deglobalization, these Chinese companies stand to ben- efit the most from the country’s continued rise to developed market status on the back of a massive middle class with rising disposable incomes. Identifying and gaining exposure to these companies requires indexes that incorporate a stock selection methodology founded on the concepts of quality fundamentals. It also requires long-term thinking, particularly at a time when investors might be reevaluating their China exposure based on geopolitical tensions. While this political conflict will be with us for years, the benefits from China’s ongoing economic growth will continue to accrue to the country’s best companies, especially if foreign firms disengage from the country in the next few years. Therefore, it is incumbent upon investors to decide how to best participate in China’s domestic growth and benchmark their exposure to Chinese equities. The MarketGrader China Growth Leaders Index, which collects the country’s most fundamentally sound companies and largely excludes SOEs as a an outcome of selection, might be one such benchmark.