Big Door Opens To Smaller Chinese Companies

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Includes: ECNS, HAO-OLD
by: AllianceBernstein (AB)

By Liliana Castillo Dearth

Structural changes in Chinese stock markets are opening up an entire world of smaller-cap stocks to foreign investors. But with valuations high and profitability low, make sure you know what you're buying before diving in.

Until recently, foreign investors had restricted pathways to Chinese companies. They could invest only via the relatively small pool of H shares in Hong Kong, Chinese ADRs and companies with high exposure to China listed in Taiwan and Hong Kong. China A shares, listed in Shanghai, were largely off limits to outsiders.

Not anymore. Today, China is pushing through major reforms and initiatives such as the Shanghai-Hong Kong Stock Connect, and the pending Shenzhen-Hong Kong Stock Connect, which provide new access routes for global investors. The inclusion of A shares in major global indices such as those of Russell (and potentially MSCI) is also sucking in money. Still, the market remains volatile. The MSCI China A Share Index surged 62% this year in US-dollar terms, to peak on June 12, and since then has dropped 28% through July 6.

Recent declines may make it seem like now is an enticing moment for aficionados of smaller stocks. Access to the A share market will open the door to 1,818 smaller companies with market caps of between US$200 million and US$3 billion, according to FactSet and CLSA. But with limited access to information, it will take time for investors to develop fundamental, differentiated views on these companies. Still, we think it's worth the effort: a finely honed stock selection process can help identify Chinese companies that are capable of delivering sustainable attractive returns for small-cap portfolios.

Size and Scope

It's hard to know where to begin. The total market cap of China A shares below the US$3 billion market cap is US$4.7 trillion-52% of the entire China market. That's on par with the US$4.7 trillion market cap of the MSCI ACWI ex US Small Cap Index. Industrials, consumer and materials are the largest sectors among smaller Chinese companies (Display, left), much like among their larger-cap peers. Yet some industries are absent among small-caps, including banks, beverages, biotech and life sciences.

The ownership structure is very different, though. While large-cap is highly dominated by state-owned enterprises (SOEs), the small-cap universe includes more private companies. In fact, 65% of small-cap companies are private, versus 52% of large-cap. Since the financial crisis in 2008, private companies in China have outperformed SOEs and now trade at a hefty premium (Display above).

Hurdles to Investment

It will take time for companies to adjust to foreign investor interest. Currently, many small-cap companies are used to presenting results at annual assemblies and aren't readily available for one-on-one meetings with foreign investors.

Returns and profitability are mixed. The average return on equity of China A share small-caps is about 5.9%-about 40% lower than Asian peers' (excluding Japan) (Display). Profit margins in 2014 were also relatively low, excluding the telecom, utilities, energy and healthcare sectors. On the surface, the combination of high valuations and low profitability doesn't look compelling.

Analyst coverage is negligible. About 58% of China A share small-caps aren't covered by any analysts, compared with 39% of large-caps, according to FactSet. Often, reports are written only in Mandarin. But this lack of coverage can also create opportunities for investors who are willing to roll up their sleeves and do hard work to discover attractive small-cap companies.

Focus on Key Growth Themes

In our view, some of the most interesting companies are beneficiaries of key growth themes. For example, rising incomes can spur demand for new products-such as contact lenses. We expect the penetration rate of contact lenses in China to rise from about 5% today to between 15% and 20% by 2020, on par with other developing Asian countries. Ginko International, based in Taiwan, is a leading contact lens manufacturer with 30% of the Chinese market, and should benefit from this trend. The company trades today in Taiwan with a market cap of about US$1.2 billion.

China's approach to the environment is also changing. CT Environmental, an industrial wastewater treatment company that is listed in Hong Kong with a market cap of US$2 billion, should benefit from the government's growing green awareness.

Rising incomes, environmental efforts and urbanization are among the big themes that we believe will create compelling opportunities in less-known companies across China's equity landscape. But proceed with caution: don't rush to invest as the market ebbs. It's important to do extensive homework on a company's growth path, competitive strengths and management execution, in order to develop clarity and conviction in Chinese small-caps.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.