ECNS: Small-Cap Chinese Equities Look Attractive
- ECNS is a Chinese small-cap fund offered by iShares, an alternative to its MCHI fund that prefers larger-cap Chinese companies.
- MCHI still looks fairly pricey. Yet in spite of the fact that ECNS followed MCHI lower in its recent correction, ECNS looks relatively cheap.
- Using the same market risk premium as MCHI, ECNS might offer as much as 30% upside.
- ECNS is also no more volatile than MCHI, and is more diversified across both sectors and its individual holdings.
- For the U.S. investor that is bullish on China, I think ECNS is an attractive long-term hold. MCHI is less exciting.
In a recent article I was lucky to time a correction in Chinese equities; in that article, I thought (and still think) that mainstream Chinese equities looked rather expensive. That is, at least in the short term. However, small-cap equities look more attractive. In my previous (referenced) article, I looked at the iShares MSCI China ETF (NASDAQ:MCHI) which is a popular iShares fund that offers U.S. investors the chance to gain direct exposure to major Chinese equities. It can be used to express a single-country view.
Another iShares fund can be used to express a 'long' view on China, and that fund is the iShares MSCI China Small-Cap ETF (NYSEARCA:NYSEARCA:ECNS). As the name of the fund suggests, this fund invests in an array of smaller companies (smaller on average than those in the MCHI fund, by market capitalization). The expense ratio is 0.59%, the same as the MCHI fund.
The ECNS portfolio consists of 264 holdings as of April 1, 2021, and the largest sector exposures are: Consumer Discretionary (21.02% of the fund), Real Estate (17.74%), Information Technology (11.96%), Health Care (10.95%), and Industrials (10.94%). The fund is fairly well diversified; the largest single-name holding is GCL-Poly (OTCPK:GCPEF) (OTC:GCPEY), a green energy supplier. This company still only represents 4.42% of the portfolio.
Comparing data from iShares for both ECNS and MCHI, we can see that ECNS trades at a much lower valuation. The price-to-book ratio for ECNS is just 1.07 as compared to 2.43 for MCHI. The P/E ratio is 10.79 for ECNS, as compared to 18.11 for MCHI. ECNS's price is not higher-beta either (it is generally not a more volatile instrument). ECNS has attracted only $105.7 million in assets, while MCHI has attracted over $6.6 billion. MCHI is clearly the more popular fund, but ECNS should be far more popular in my opinion.
If I were an American investor looking to invest in Chinese equities tomorrow, I would not chase the major-cap stocks that funds such as MCHI prefers (by design), but rather a fund like ECNS which spreads its risk across many smaller equities. In past articles I have touched upon Chinese politics, how the megacaps of China will likely continue to face greater political headwinds than their North American counterparts. Investing in the smaller companies of China through funds such as ECNS will help investors circumvent (somewhat) this political risk. Smaller companies are much less likely to face political challenge, while ECNS is far less concentrated than MCHI (the latter's largest holding is Tencent Holdings Ltd. (OTCPK:TCEHY). Tencent represents 15.45% of the MCHI fund, which is about 3.5x as large as ECNS's leading stock as a proportion of fund assets.
Based on Morningstar data, the forward price/earnings ratio of ECNS is just 8.95x. Inverting the ratio implies a forward earnings yield of about 11.2%. Using Professor Damodaran's equity risk premium estimate for China of 5.4%, and adding the present 10-year Chinese government bond yield of 3.2%, implies a total market risk premium (or MRP) of 8.6%. To normalize the forward earnings yield to the MRP, we would need to see upside of 30% (in the share price of ECNS).
Perhaps you want to price in greater risk to test the margin of safety here. We can experiment by increasing the equity risk premium by 50%, taking it from 5.4% (as above) to 8.1%. Adding back in the risk-free rate (on the domestic 10-year) of 3.2%, we find an adjusted MRP of 11.3%. This would imply downside of about 1%, but in effect it would imply ECNS is trading at fair value. However, this is applying a 50% "premium" to the equity risk premium for investing in China's small caps (over its large caps), a premium I am not sure is particularly justified since I frankly see more risk in some of the majors than the minors of corporate China.
In any case, I think investors in China's small-cap world (provided they are diversified such as through funds like ECNS) will be compensated for the risk of doing so. The U.S. investor should probably not be tempted to invest the entirety of his or her portfolio in Chinese equities, but if geographical diversification is the goal (and I continue to think it makes sense, given how pricey U.S. stocks are at present), ECNS looks like an effective instrument to gain exposure to China, a country which is on the rise but whose main market also seems a little pricey to me.
ECNS has the additional bonus of being diversified across various sectors, rather than being highly concentrated in technology or consumer stocks. As evidenced below, you get exposure to Cyclical, Sensitive, and Defensive stocks; there is no strong bias anywhere, and as such I view ECNS as a far "purer" way of expressing a single-country view with respect to China.
In terms of FX, the Chinese yuan is possibly modestly overvalued relative to the U.S. dollar. The Economist's GDP-adjusted Big Mac Index (as illustrated below) indicates a potential gap of around 3%. However, given the level of potential upside in the ECNS price, this is probably only a modest risk to consider. The yuan could crater for other reasons, but the 10-year Chinese government bond yield of 3.2%, as cited above, still beats the U.S. equivalent of 1.7%.
(Source: The Economist)
Therefore, while the U.S. dollar has fallen by around 5.7% since January 2020 (pre-pandemic), I do not necessarily see a notable FX risk here. Increased political tensions could see a weaker yuan, but much has happened over the past five years or so, especially since the start of Trump's administration (inaugurated January 20, 2017). Yet flows into China have been robust (see below for quarter-over-quarter fund flows into China; Mexico also included).
(Source: Robin Brooks, IIF)
A continued rise in the economic power of China is likely, even with increased political tensions; indeed, I would expect a continuation of the latter is largely dependent on (driven by) the former. You do not have to take sides to believe that the long-term investment case for China is still intact. As recently as 2019, per-annum Chinese GDP per capita growth still exceeded the U.S. comparable by about 3.9%. ECNS looks like a great long-term hold.
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