The CSI MarketGrader China New Economy Index (CNE) managed to avoid the worst of the fallout from rout in the education and technology stocks that have been in Chinese regulators’ crosshairs in the last two weeks. Despite this, the Index has fallen steeply along with most Chinese equities traded globally in the last week and a half. We have reasons to believe the selloff will be short lived and that CNE will come out ahead on the other side. Here’s why.
Following the recent selloff (through July 28th) CNE’s constituents traded at a median trailing P/E of 20.6, the Index’s lowest valuation since January 2019, when the median was 20.0. The current valuation represents a 32% discount to the Index’s valuation in August 2020, when it peaked following a massive post-Covid run up, as illustrated in Figure 1. The last time CNE had experienced a significant decline in its median trailing P/E was November 2019, when the multiple fell to 21.3 (still 3.4% above the current level) from 27 in March 2019. That multiple compression was followed by a 54.6% rise in the Index (price returns in AUD) until it peaked nine months later in August 2020. Furthermore, CNE was up 49.3% between November 2019 and July 21, 2021, when the recent drawdown began in earnest. Following the recent selloff in China, the index is now up ‘only’ 35.8% since November 2019.
Figure 1. Historical P/E for CSI MarketGrader China New Economy Index
Recent regulatory actions in China have zeroed in on technology companies, including tutoring and education services, ride hailing, payment processing, and food delivery. Since some of the most visible names in these industries trade offshore (in Hong Kong or as U.S. ADRs), foreign investors have often conflated the government’s actions with a desire to punish foreign shareholders, dissuade companies from continuing to list overseas, or both. We disagree with this view since the issue of overseas Chinese listings is complex and not one that we think the government is likely to address hastily given all the potential consequences it might have for some of its own national technology champions. To be clear, though, we do believe the risk of owning Chinese companies through foreign listings, especially those in the U.S. using a VIE structure (variable interest entity) has increased significantly and should be top of mind for investors accessing China mostly through offshore listings.
Luckily for the shareholders of the ETF that tracks our Index in Australia, the VanEck China New Economy ETF (ASX: CNEW), the CNE selects only among onshore listings, or A shares. In a somewhat perverse twist, we think owners of A shares might benefit from flows out of offshore names and into domestic issues, as institutions globally reassess their China exposure. Put differently, we don’t believe the most recent pullback will make investors questions their willingness to own Chinese equities given the size of the market, the economy’s growth rate, and the tremendous upside potential. Instead, we think some investors might choose to de-risk their China exposure by going full A share, either through foreign quotas granted by the government or through the Stock Connect program in Hong Kong.
While recent drawdowns haven’t been pleasant to any owners of Chinese shares, some have fared better than others. We won’t delve into the myriad exposures tracking Chinese stocks but instead look at how some key benchmarks have done based on their size exposure and their onshore vs. offshore exposure. We looked at the year-to-date performance of a series of indexes (based on AUD price returns through July 27th) to see how CNE has done relative to some of its peers. The results appear in Figure 2.
Figure 2. YTD Returns for Select China Indexes (through July 27, 2021)
|A-Share Benchmarks||YTD Returns|
|CSI 300 Index (Large Cap benchmark)||-4.5%|
|CSI 500 Index (Small Cap benchmark)||+10.6%|
|CSI All Share Index (broad market benchmark)||+2.8%|
|Offshore (or offshore-heavy) Benchmarks|
|MSCI China Index (67% HK, 18% U.S.)||-14.3%|
|Nasdaq Golden Dragon Index (100% U.S.)||-28.1%|
|CSI Overseas China Internet Index (100% offshore)||-36.4%|
|CSI MarketGrader China New Economy Index||+3.1%|
Large caps have clearly felt the effect of the drawdown much more than small caps for two simple reasons. First, as stock exposures are unwound, the largest companies in the benchmark must, by definition, be sold in proportion to their weight in the index. Second, there’s a perception among Chinese investors that smaller companies might be better insulated from additional regulatory risk simply by virtue of their size. Smaller companies simply pose less of a systemic risk than larger ones.
For investors owning the mostly offshore benchmarks, the magnitude of their drawdowns can obviously be attributed to the fact that most of the companies that have been subjected to new regulatory scrutiny are listed overseas.
A question we often hear from investors is: which is the next industry to get in the regulators’ sights? While this is impossible to answer, we have a hard time seeing significantly disruptive regulations to a broad swath of companies in CNE. For starters, most of the companies that have been disrupted recently have had one thing in common (with a couple of exceptions among some of the education stocks): size. When we look at the 20 largest companies in CNE, we don’t see any that we think might be deemed “systemically risky” by the government. In fact, the four largest companies are in the Consumer Staples Sector. CNE is not a small cap index, but it does behave more like a small/mid index for two key reasons: First, it is an equally weighted index, so at each rebalance each index constituent is re-weighted to 0.83% of the entire index regardless of its size. Second, the largest companies in China are the large technology platforms such as Alibaba, Tencent, and Meituan, the large state-owned banks, the large insurance companies, the large state-owned energy companies and utilities, and some of the liquor companies. CNE doesn’t own any of the large tech platforms, because they are all listed offshore; and it doesn’t own any of the banks, insurers, or “old economy” sector stocks by design. So, among the largest companies in China, CNE only owns the liquor companies. Given its makeup, we don’t see broad regulatory risk across the portfolio; having said that, this is a China exposure and government risk should always be considered as a potential factor affecting future investment returns.