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Grasping The Value Of China's Mid-Caps

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Includes: CHN, CN, CXSE, FCA, FLCH, FXP, GXC, KGRN, PGJ, TDF, WCHN, XPP, YANG, YINN, YXI
by: FTSE Russell
Summary

Although China's capital markets have struggled in recent months on the back of a declining RMB and trade war jitters, the bulls have not disappeared completely.

The gap between large-cap A-Shares and mid-cap A-Shares has widened in recent months.

Unlike many of the SOEs, many China mid-caps are champions not only of China's economic past but also its future.

By Christopher Vass, Senior Product Manager, APAC

Although China's capital markets have struggled in recent months on the back of a declining RMB and trade war jitters, the bulls have not disappeared completely. The Shanghai Composite Index delivered its strongest performance since June in the first week of September, closing up 3.9 percent - which China's regulators capitalised on by declaring a reserve ratio cut after the market closed on September 6.[1]

As Q3 draws to a close, one segment of China's markets deserving of more commentary and analysis is China's mid-cap segment. Since mid-2016, China's mid-cap A-Shares have underperformed large-cap A-Shares - which largely consist of China's well-known state-owned enterprises (SOEs).

In fact, the gap between large-cap A-Shares and mid-cap A-Shares has widened in recent months, with some analysts claiming that an uncertain outlook is putting a damper on appetite for China's smaller and lesser-known companies. Put another way: in turbulent times, investors are predictably favouring so-called 'safe' trades.

The data bears this out: In 2018, Chinese large-caps outperformed small and mid-caps for the first time in 10 years, suggesting to some analysts that China investors are "running out of ideas" and are clinging to "easy targets."[2]

In terms of their total return, the FTSE China A Mid Cap constituents have returned to 2014 levels, as illustrated by the chart below. While that may be disappointing to those investors looking for the peaks of 2015, some analysts suggest the time could be ripe for more investor interest in mid-caps, as they haven't returned to previous highs.

Agents of China's 'new economy'

Unlike many of the SOEs, many China mid-caps are champions not only of China's economic past but also its future - broadly defined as an increasingly 'tech-focused' economy driven by innovation and domestic consumption. This contrasts with China's corporate giants, which fuelled the country's historic macroeconomic growth in recent decades in areas such as banking and natural resources.

Case in point: When the Shanghai stock index surged in March on the back of monetary easing and optimism that the trade war was nearing a resolution, it was China's mid-caps (especially telecoms) that dominated the rally. For one specific example, shares in Eastern Communications surged 752 percent between late November 2018 and mid-March 2019, due to market speculation that the firm is set to benefit from China's 5G plans.[3]

The technology sector is heavily featured in China's mid-cap segment. In fact, China's technology companies are now assigned higher weightage in the mid-cap segment compared to large-caps, as per the Industry Classification Benchmark (ICB) Supersector Breakdown.

Similarly, Chinese mid-caps in other sectors that can be classified as 'new economy' such as retail, healthcare, and personal and household goods are also now assigned higher weightage in the mid-caps category.

And if that's not enough to warrant more attention to mid-caps, on September 10th, the State Administration of Foreign Exchange announced that it plans to scrap foreign investment limits under the Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) schemes, ending a decades-long policy[4], and potentially unleashing more foreign investment into A-Shares.

The news bodes well for investors interested in China's mid-caps, which are at the vanguard of China's 'new economy' and will likely play a vital role in the country's overall development in the decade ahead.

[1] https://www.bloomberg.com/news/articles/2019-09-06/china-stocks-turn-hot-lure-most-foreign-inflows-since-february

[2] https://www.cnbc.com/video/2018/02/22/look-for-small-and-mid-cap-chinese-companies-instead-strategist.html

[3] https://www.reuters.com/article/us-china-markets-stocks/retail-investors-mid-caps-stand-out-in-chinas-stock-rally-idUSKCN1QW12J

[4] https://www.bloomberg.com/opinion/articles/2019-09-10/china-scrapping-qfii-quotas-hints-at-desperation-for-money

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