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    Understanding China’s Market Paradox—and Opportunity

    Carlos Diez, MarketGrader
    July 15, 2020
     

    This blog is adapted from the white paper, “Chinese Equity Market Paradox”, published by MarketGrader.

    The total market capitalization of China’s domestic equity universe trading on the Shanghai and Shenzhen exchanges grew from USD 3.6 trillion in 2010 to USD 8.5 trillion in 2019, an annualized growth of 9.1%. However, an investor in Chinese stocks trying to translate this growth into portfolio returns would have been bitterly disappointed. Over the same period, an investment in China’s broadest benchmark, the CSI All Share Index would have resulted in an annualized return of only 1.6%1, which failed to even keep up with the country’s annualized rate of inflation of 2.5%2.

    A large part of this underperformance can be explained by the dual ownership structure of state-owned enterprises (SOEs). This led to both a massive overhang of state-owned shares as well as the sometimes contradictory objectives between state and private owners, which gave rise to a culture within many SOEs of stagnation, inefficiency and bureaucracy, resulting in dismal stock returns. With a market capitalization of USD 4.7 trillion, SOEs account for 58% of the entire A-share market and comprise 69% of the CSI 300 Index, 50% of MSCI China Index’s and 48% of the FTSE China 50 Index’s total market capitalization.3

    Many would argue that the simplest way to address this would be to exclude SOEs from the benchmark or from an investment portfolio. However, this is a blunt solution to a problem that requires a finer approach—especially because there are plenty of high quality SOEs in dynamic areas of China’s economy that are often overlooked or underweighted by broad market indices. For instance, Wuliangye Yibin Co., a profitable state-owned beverage manufacturer with a 4.75% weight in the MarketGrader China Growth Leaders Index has a small weight in MSCI China and is not included in CSI 300 or FTSE China 50 indices.

    Access the Entire China Opportunity Set

    Investors interested in China’s stock market can avoid the pitfalls of overexposure to inefficient, slow-growth SOEs through a stock selection methodology that is more attuned to the true drivers of Chinese economic growth. MarketGrader selects companies that are growing at a faster rate than the overall economy and that possess attributes associated with sound capital stewardship and robust fundamentals, but whose future value is not yet reflected in their share price. The result is a higher quality and growth profile of companies in the MarketGrader All-Cap China Growth Leaders Index versus other broad-based China benchmarks. This can be seen in a variety of metrics, two of which are shown below.

    Percentage of Index Constitutions with 3-Year Sale Growth by Select Ranges Percentage of Index Constitutions with 3-Year Sale Growth by Select Ranges

    Source: FactSet; MarketGrader; China Securities Index Co. Sales growth is measured as the most recent trailing 12-month figures compared to the figures for the 12 months ended three years earlier, excluding companies in the Financial sector.

    46% of the constituents of MarketGrader’s Growth Leaders Index have more than doubled sales in the last three years (in fact 16% have more than tripled sales), compared to only 27% for the constituents of the CSI 300 Index, and 29% of the constituents of the MSCI China Index. Perhaps the most telling amongst all the metrics, especially in the context of the oversized role SOEs play in China’s equity market, is that three-quarters of all SOEs in China have a return on equity below 10%. This confirms the thesis that these companies’ financial decisions have little to do with generating shareholder returns and much to do with acting as agents on behalf of the Chinese state in its various forms. By comparison, 42% of all companies in the CSI 300 and the MSCI China indices had a return on equity below 10%. For MarketGrader’s China Growth Leaders Index, the number was only 11%.

    Return on Equity, Trailing 12 Months, by Select RangesReturn on Equity, Trailing 12 Months, by Select Ranges

    Source: FactSet; Market Grader; China Securities Index Co. Data as of April 2020 and excludes all indices’ constituents in the Financials sector.

    How to Invest

    The VanEck Vectors® China Growth Leaders ETF (GLCN) seeks to replicate as closely as possible, before fees and expenses, the price and yield performance of the MarketGrader China All-Cap Growth Leaders Index (MGCNGRNR). The Index consists of 200 companies domiciled in China that the index provider has determined exhibit favorable fundamental characteristics.

    See also the second blog in the series: Build a Better China Portfolio

    Important Disclosures

    Source: China Securities Index Company (CSI)

    Inflation, consumer prices (annual %) – China. Source: World Bank 

    China Securities Index Co. for CSI SOE Composite and CSI 300; FactSet for MSCI China and FTSE China 50 constituents.

    This content is published in the United States for residents of specified countries. Investors are subject to securities and tax regulations within their applicable jurisdictions that are not addressed on this content. Nothing in this content should be considered a solicitation to buy or an offer to sell shares of any investment in any jurisdiction where the offer or solicitation would be unlawful under the securities laws of such jurisdiction, nor is it intended as investment, tax, financial, or legal advice. Investors should seek such professional advice for their particular situation and jurisdiction.

    MarketGrader China All-Cap Growth Leaders Index consists of 200 companies domiciled in China that the index provider has determined exhibit favorable fundamental characteristics.

    The CSI All Share Index includes all the A-shares except ST stocks and *ST stocks and the stocks which has been listed less than three months.

    The CSI 300 Index is a free-float market capitalization weighted index compiled and managed by China Securities Index Co. Ltd. consisting of 300 A-share stocks listed on the Shenzen and/or Shanghai Stock Exchanges.

    The MSCI China Index captures large and mid cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (e.g. ADRs). With 704 constituents, the index covers about 85% of this China equity universe.

    The FTSE China 50 Index tracks 50 of the largest and most liquid companies in China. These equities trade on the Hong Kong Stock Exchange and are weighted based on market cap.

    An investment in the VanEck Vectors China Growth Leaders ETF may be subject to risks associated with investments in Chinese securities, including A-shares, which include risk of the RQFII regime and Stock Connect program, foreign and emerging markets investments. In addition, the Fund is subject to foreign currency risk, non-diversification risk, and other risks associated with investing in the consumer discretionary sector, consumer staples sector, financials sector, industrials sector, swaps, futures, investing in other funds, small-and medium capitalization companies, cash transactions, equity securities, market, operational, index tracking, authorized participant concentration, no guarantee of active trading, passive management, fund shares trading, premium/discount risk and liquidity of fund shares and concentration risks, all of which may adversely affect the Fund.

    The Fund may gain exposure to the China A-Share market by directly investing in China A-Shares and investing in swaps that are linked to the performance of China A-Shares. An investment in the Fund involves a significant degree of risk, including, but not limited to, risk of the RQFII regime and the Fund’s principal investment strategy, investing in China and A-shares, investing through Stock Connect, foreign securities, emerging market issuers, foreign currency, consumer discretionary sector, consumer staples sector, financials sector, investing in swaps, futures, other funds, small-and medium-capitalization companies, cash transactions, equity securities, market, operational, index tracking, authorized participant concentration, no guarantee of active trading market, trading issues, passive management, fund shares trading, premium/discount risk and liquidity of fund shares, non-diversification, concentration risks and the Adviser’s and Sub-adviser’s ability to manage the Fund, which depends upon the availability of China A-Shares and the willingness of swap counterparties to engage in swaps linked to the performance of China A-shares all of which may adversely affect the Fund. The Fund may invest in derivatives, which entail certain risks, including counterparty, liquidity, and tax risks (including short-term capital gains and/or ordinary income). Foreign and emerging markets investments are subject to risks, which include changes in economic and political conditions, foreign currency fluctuations, changes in foreign regulations, and changes in currency exchange rates which may negatively impact the Fund’s returns. The Fund may also invest in shares of other funds and absorb duplicate levels of fees with respect to these investments. Small-and Medium-capitalization companies may be subject to elevated risks.

    Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of the Fund carefully before investing. To obtain a prospectus and summary prospectus, which contains this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.