The CSI 300 Index, a benchmark of the 300 largest companies in China’s A share market, started 2021 with a bang. In the first trading week of the year it topped its previous all-time high, reached in June 2015, as Chinese stocks resumed their 2020 thrust upward that saw the benchmark gain 27% in 2021. Investors who experienced China’s 2015 market crash, in which the CSI 300 followed a 51% climb in the first five months of the year with a dizzying 40% drop in less than four months (Figure 1), fret that a repeat might be in the cards. The index has gained 89% since its December 2018 bottom and is up over 11% so far this year. While we agree that China’s equity market is showing signs of stress, a more apt comparison would be to the U.S. equity market in early 2000, rather than to China’s own 2015 margin lending-driven craze.
Figure 1. Cumulative Price Return of CSI 300 Index in 2015 in CNY
In the year leading to May 2015, a month before China’s equity market crashed, Mainland Chinese stocks had surged by 119% in Shanghai and 121% in Shenzhen, cheered on by a government eager to steer investors away from the red-hot real estate market. Domestic investors, flush with savings and unable to invest overseas, were opening brokerage accounts to the tune of 4.1 million a week, while margin balances climbed over 400% in a little over a year. As the rally ran out of steam in June, the government panicked and implemented a flurry of trading suspensions and market interventions that only exacerbated the selloff. Speculators and leveraged funds that had borrowed at floating short-term rates to build up leveraged equity positions rushed for the exits, turning the correction into a full-fledged rout. China’s equity market today, however, is not the same market as in 2015 thanks to greater participation by institutional and foreign investors and much tighter regulations of fund management companies and brokerage firms. The market is deeper, more liquid, and has about a third more listed companies than it did in 2015. Today’s risks, in our view, can be attributed to other factors with which U.S. investors became familiar in 2000: extreme levels of concentration in a few mega-cap stocks in the market cap-weighted benchmarks; unsustainable valuations among some of those same large, concentrated positions; and poor market breadth as further surges upward are led by fewer names.
Concentration Risk
The five largest stocks in the CSI 300 Index currently account for 18.2% of its total weight, which is actually less than the almost 21% total weight of the S&P 500’s five largest companies. However, while the S&P 500’s five largest holdings are Apple, Microsoft, Amazon, Facebook and Tesla, companies with largely global footprints, the five largest companies in the CSI 300 Index are mostly leveraged to China’s domestic economy. They include two liquor companies (Kweichow Moutai and Wuliangye Yibin), one insurance company (Ping An Insurance Group), a large state-owned bank (China Merchants Bank) and an appliance maker (Midea Group). All five of them, by the way, have positive MarketGrader ratings and pretty solid businesses (although their value grades have deteriorated significantly in the last year). Our concern isn’t so much with the quality of the companies, nor with their dependence on their large, domestic market (about which we have written favorably many times before) but with how dominant they have become in the market cap weighted benchmarks, which has made China’s current bull market dangerously dependent on them. Consider, for example, that in an even more concentrated A share benchmark, the FTSE China A50 Index, the top five companies (five of those mentioned above plus Industrial Bank of China instead of Midea Group), account for a whopping 39% of the index’s weight. Figure 2 illustrates this concentration.
Figure 2. Cumulative Concentration of Select Chinese Indexes in Top Five Stocks
| CSI 300 Index | Weight | FTSE China A50 Index | Weight |
| Kweichow Moutai | 5.4% | Kweichow Moutai | 11.8% |
| Ping An Insurance Group | 4.3% | Ping An Insurance Group | 9.2% |
| China Merchants Bank | 3.2% | China Merchants Bank | 7.6% |
| Wuliangye Yibin | 2.9% | Wuliangye Yibin | 6.5% |
| Midea Group | 2.4% | Industrial Bank | 4.1% |
| Top 5 Total Weight | 18.2% | Top 5 Total Weight | 39.2% |
Valuation Risk
Among the companies in the CSI 300 Index and the FTSE China A50 Index mentioned above, two are of particular concern: Kweichow Moutai (600519.CN) and Wuliangye Yibin (000858.CN), which are now not only China’s two largest liquor companies, but also the two largest in the world by market capitalization. Ironically, these are companies that MarketGrader has not only rated highly for years, but also stocks we have selected to several of our China indexes. In fact, Wuliangye Yibin is currently a member of five MarketGrader indexes, including the CSI MarketGrader China New Economy Index, although the stock only accounts for 0.8% of the index given that its constituents are equally weighted. Kweichow Moutai, on the other hand, had been selected to the CSI MarketGrader China New Economy Index in every single semi-annual selection period, dating back to 2007[1], up until the index’s last rebalance in December, when it missed the cut for the very first time largely as a result of its valuation. The stock, which gained 69% in 2020 alone, appreciated by 1,056% since 2007, when it was first selected to our New Economy Index, growing from a $30 billion market cap company to the 13th most valuable company in the world[2]. And while most of the company’s financial results continue to be outstanding, the price investors are currently paying for the company’s projected earnings should give them some pause, especially considering it will need to grow from a much larger base than it did a few years ago. Consider this: the company immediately above it in our global market cap ranking is Samsung Electronics with a $505 billion market cap[3], only $40 billion larger than Kweichow Moutai; however, Samsung generated $212 billion in trailing 12-months sales and $23.5 billion in trailing 12-month net profit through its most recently reported quarter, compared to $12.5 billion and $6.9 billion, respectively, for Kweichow Moutai. Samsung’s shares trade at 23 times trailing earnings per share and 15 times one-year forward earnings, while Kweichow Moutai’s trade at 69 times trailing EPS and 58 times forward EPS.
Wuliangye Yibin, meanwhile, is smaller in size than Kweichow Moutai but its valuation multiples are similar; its shares trade at 64 times trailing EPS and 52 times forward EPS. It garnered $7.4 billion in revenue and $3 billion in net profit through its most recently reported 12-month period. Both companies are highly profitable, have enviable margins and are prodigious cash flow generating machines and, as we show below, both of these companies’ stocks have vastly outpaced the broad Chinese market in the last year. Given their outsized share of the broad market cap benchmarks (a combined 8.3% of the CSI 300 Index and 18.3% of the FTSE China A50 Index), investors should pay close attention to their Chinese equity exposures through some of the country’s market cap weighted indexes
Declining Market Breadth
Blockbuster years such as 2020 often obscure important trends underlying equity rallies as investors overlook telltale signs of a tiring bull market. Market leadership and market breadth indicators are often good measures to watch after strong market rallies. For investors in Chinese equities, last year was a remarkable year, no matter which benchmark they followed. The CSI 300 Index gained 27%, excluding dividends, while the CSI All Share, the broadest measure of Mainland China’s equity opportunity set, gained 25%. Our own CSI MarketGrader China New Economy Index surged 31%, while the CSI 500 Index, a measure of China’s small caps, gained 21%. The year’s standouts, though, were the ChiNext Index, up 65% and its smaller sibling, the SME ChiNext 100, which gained 59%[4] (Figure 3).
Figure 3. Cumulative Price Return for Select Chinese Benchmarks in 2020 (CNY)
However, a closer look at what happened in 2020 reveals a tale of two halves; the CSI All Share Index, covering all investable stocks in Shanghai and Shenzhen, gained 25% through early July but then had a 0.3% return during the year’s second half. The CSI 500 Index, China’s small cap benchmark, gained 31% also through early July but then proceeded to decline 8% during the back half of 2020. Likeweise, stellar performers during the year’s first semester, including the CSI MarketGrader China New Economy Index, ChiNext and SME ChiNext had second semester returns of -12%, 3% and 6%, respectively. Meanwhile, four of CSI 300 Index’s five largest holdings, Kweichow Moutai, China Merchants Bank, Wuliangye Yibin, and Midea Group had second semester returns that averaged 30%, as illustrated in Figure 4. In other words, as China’s market soared in 2020, market leadership narrowed to just a few of the market’s largest names, which carry an oversized weight in the market cap benchmarks. Meanwhile small cap stocks, mid cap stocks, and new economy stocks gradually fell as reflected by smaller cap benchmarks or, in the case of the CSI MarketGrader New Economy, equally weighted indexes.
Figure 4. Cumulative Price Returns for Select Chinese Benchmarks and Select Stocks between July 13, 2020 and December 31, 2020 (CNY)
Another way of looking at the gradually declining breadth of market leadership is by measuring, over time, the number of stocks that rise on any given day relative to those that fall. In a healthy market rally with broad stock and sector participation it isn’t unusual to see three to four issues advancing for every issue that declines. This is exactly what was happening in China in early 2020 as investors anticipated a return to higher economic activity following the country’s draconian shutdowns and massive quarantines in the early days of the coronavirus pandemic. Market breadth peaked in China between late March and early April, when the 30-day average number of advancing issues reached 4.7 for every single stock that declined. By August the 30-day average had fallen below three and by the end of the year below 1.5. As of this writing, only 1.1 stocks in China were advancing for every stock that was declining daily, based on a rolling 30-day average. This trend can be seen clearly in Figure 5.
Figure 5. 30-Day Average of Advance/Decline Ratio for Issues Listed on the Shanghai and Shenzhen Stock Exchanges, Dec 2019 to Feb 2021
Investors that have followed MarketGrader for some time know how strongly we feel about opportunity for very significant capital appreciation in Chinese equities in the long run. However, as market leadership continues to narrow and valuations stretch in some pockets of the market, investors will be well advised to avoid concentrating their bets too narrowly or chasing gains in the market cap benchmarks. Sooner or later fundamentals will reclaim their importance in setting long-term equity returns and in China, despite the country’s impressive economic growth, this is no different.
[1] The CSI MarketGrader China New Economy Index was first published on March 20, 2015. All figures prior to that date are based on back-tested performance.
[2] Market capitalization ranking as of February 10, 2021. Source: MarketGrader.
[3] Samsung Electronics market capitalization as of February 10, 2021. Source: MarketGrader.
[4] All index returns cited throughout this article are price-only and calculated in CNY. Source: Bloomberg.
