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Hugh Young: China’s domestic equities’ time to shine

It is vital passive investors know what they are holding if China A-Shares make it into the MSCI Emerging Markets index

MSCI executives have met with equity market practitioners every June since 2014 to decide whether to add China A-shares to the company’s influential global indices. So far they have always found reason to demur and extend the review process another 12 months.

This year, the likelihood of success has never been greater. MSCI has slashed the number slated for inclusion than previously proposed. Initially, only 169 of the largest A-share companies will be added. For the first time ever, foreign fund managers are supporting the plan.

Even at 0.5 per cent of the MSCI Emerging Markets index, billions of dollars of passive money will need to be reallocated into Chinese equities to reflect the changes, marking a further step in China’s integration into global financial markets.

Our investment views on China have evolved since the early days when we had big reservations about its equities and domestic financial markets. What held us back in the past were issues such as lack of transparency, indifference to minority shareholders and companies that are not run for profit.

However, our confidence in Chinese companies is rising – albeit slowly. China is changing. New patterns of growth favour nimble private sector companies which operate in a highly competitive environment (unlike those in the state sector) and demonstrate more discipline.

Domestic consumption accounts for more than half of the economy and we believe the key to unlocking shareholder value is to identify those companies that can tap into growing disposable incomes, while operating largely free from government interference.

The A-share market offers the largest pool of Chinese companies, with some firms having the potential to become market leaders domestically, and even globally.

Our holdings include a renowned traditional Chinese medicine-maker, the country’s largest CCTV surveillance system provider, a supermarket chain and a leading cement manufacturer.

In the area of corporate governance specifically, even state-backed Baosteel Group has moved with the times. Last year, it approached its shareholders for feedback as part of its review of dividend and share buyback policies.

What are A-shares?

A-shares are stocks of mainland China-based companies, denominated in renminbi and listed in Shanghai or Shenzhen. Historically closed to foreign investors, a relaxation of rules, initially via approved investment quotas and subsequently two direct trading links through Hong Kong, has made these shares more accessible.

The gradual adoption of employee incentive programmes, such as stock option schemes, helps align management interests with those of minority shareholders and increase engagement with investors.

With rising foreign participation in financial markets, authorities are keen to inject more professionalism into the domestic fund management industry, hoping to influence Chinese companies in the process.

That said, risks abound. Good corporate governance is still the exception. Although China has financial reporting requirements on a par with developed markets, the weakness is in interpretation, implementation and enforcement because of a lack of experienced accountants, auditors and regulators. For example, connected party transactions may go unreported because the definition of a connected party may be tweaked.

Companies may also hoard cash, with dividend payout ratios that are typically lower than those linked to companies listed in Hong Kong; independent directors, often academics, may not contribute meaningfully; and internal anti-corruption controls may be weak.

The Chinese stockmarkets (and the economy) are prone to government intervention.

This creates problems when regulators are inexperienced, such as the spike in voluntary trading suspensions during the market sell-off in 2015. That is why we still tell investors with a lower tolerance for risk to access China via foreign companies that derive significant revenues from the country but whose shares are listed elsewhere.

But for those who can stomach greater volatility, there are rich rewards that can only be found within the domestic market: promising home-grown firms operating in growth areas such as consumer, transport and healthcare.

Needless to say, this is not a market for passive investors. Companies need to be monitored for a long time, management teams met and assessed, and background checks commissioned. Should MSCI decide to take the leap this year, investors around the world may find themselves owning A-shares by default. One would hope these investors understand what they own, because screening investments by size alone makes very little sense.

Hugh Young is managing director of Aberdeen Asset Management Asia

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