Updated: Feb 21, 2020
Following the inclusion of A shares in global benchmarks, foreign ownership of China A shares increased to 5.3% by the end of 2019. We identified the stocks that global institutional investors find most attractive and comment on their ESG performance.
Over the past 2 years, MSCI, FTSE Russell and S&P Dow Jones have gradually introduced China A shares in their global and emerging market indices, similar to global bond indices providers. With MSCI’s successful implementation of the 20% partial inclusion of China A shares in MSCI indexes, China A shares now contribute 0.5% and 4% in MSCI ACWI index and MSCI EM index, respectively.
This number suggests global passive funds which track global or emerging market indices will have to allocate their assets into China A shares market, while there are other active asset managers who purchase A shares through QFII/RQFII, Shanghai and Shenzhen stock connect channels. To achieve higher returns with lower volatility relative to other countries in the emerging market, as well as lower correlation with the global market, makes China A shares a preferred choice for many asset managers.
How big is the China A share market?
Shanghai stock exchange and Shenzhen stock exchange are the 4th and 8th biggest stock markets in the world.
There are over 3400 stocks in the A shares market, but if we consider the liquidity requirement by global institutional investors, the actual number of investable stocks left are around 1000 stocks. Although this method removes more than two thirds of the entire stock universe, it is still at the same level as the current total number of stocks in the emerging market indices.
According to UBS, even if MSCI China A shares inclusion factor stays constant as at 2019, passive fund allocation will approach 300 billion Yuan. Hypothetically, if the inclusion factor increases to 100%, China A shares will eventually contribute 16.6% of the MSCI EM market. As mentioned above, MSCI, FTSE and Dow Jones now include A shares into their emerging market indices, with passive fund managers now contributing 34 billion USD in capital to China.
Further to that, China recently lifted its QFII/RQFII quota restriction in September 2019 and the requirement which restricts asset management firms from full ownership will also be removed in 2020 (we will talk about this in a later episode). Therefore, we believe investment in China A shares by active fund managers will increase in 2020.
Will Chinese A shares inclusion factor increase in 2020?
China A share stocks currently have a 20% inclusion factor in MSCI EM market index which contribute to 5% of total index weight. From a local market point of view, by the end of 2019, foreign investors contribute 5.3% of Chinese A share market.
MSCI Inc. mentioned in a statement that there four main concerns which need to be addressed before they consider further increasing China A shares inclusion in MSCI indices. The concerns raised include: access to derivatives instruments as hedging tools to manage increased exposure, operational challenges regarding China’s short settlement cycle of T+0/T+1, the misalignment of trading holidays with onshore China and Hong Kong, and a lack of mechanisms to facilitate a single order on behalf of multiple clients.
Which stocks the most popular ones invested by global investors?
Global investors are most attracted to the consumer goods and health care industries. The most popular individual stocks invested by market caps are Kweichow Moutai, Midea group, Pingan Insurance, Hikvision and Norton Life lock Inc., according to Sina Finance (Feb, 2019).
If we look at the percentage of foreign ownership, it looks slightly different. In March 2019, Han's Laser, a machinery and 3D printing company based in Shenzhen, approached the 28% limit in foreign ownership, and consequently dropped off the MSCI emerging market index because of this restriction, which limits share purchase by global investors.
According to Shanghai and Shenzhen stock exchange regulation, an individual foreign investor cannot hold more than 10% of a single China A share, by total company shares outstanding, and the foreign investor cap is a 30% limit of total shares outstanding.
As of the 10th of December 2019, the foreign investor ownership in leading housing appliance company Midea Group, was 27.51% of total shares outstanding, triggering the 28% foreign ownership limit. Unlike Han's Laser, the market capitalization of Midea is currently 400 billion RMB, 10 times the market capitalization of Han's Laser. The largest foreign shareholders in Midea include Canada pension fund, Merrill Lynch international and GIC private. Midea's stock price has increased 60% since the beginning of 2019, sitting at a PE ratio of 16.1.
Centre Testing international Group, an industrial testing company, is another popular stock that approached the 28% limit line; it’s stock price increased by more than 100% since the beginning of 2019.
What is the ESG performance of China A stocks?
Over 50% of all China A share stocks included in the MSCI EM index are classified as Chinese state-owned companies, which includes companies from the banking and infrastructure sectors. Foreign investors have expressed their concerns over the strategies and approach toward ESG related issues. According to MSCI, the average ESG disclosure globally is 34%, with China A shares companies lagging behind global disclosure.
But a recent study shows that MSCI has improved the overall ESG ratings of Chinese A share stocks with 11% of listed companies achieving higher ratings compared with the previous year. The trend in ratings shows that CCC and B-rated companies are decreasing, whilst BB-rated companies are increasing. However, companies rated BBB and above currently make up less than 20%, compared to MSCI global indices and companies rated BBB and above make up more than 65% of the index globally.
Among the above most popular A shares stocks by global investors, Han's laser has gone through multiple scandals. Han's laser has dropped 12% since the latest semi-annual financial report released by the firm. It was reported that 1 billion yuan was invested in a questionable R&D team in Europe, and the CEO's stock pledge ratio was as high as 99%. We searched for Han's laser's CSR report of 2018, which is 25 pages long in Chinese language, but did not touch on the company’s corporate governance strategies.
Two board members of Hikvision, one of the world’s largest video surveillance company, were investigated by the Chinese security regulator due to a lack of transparency on internal policies regarding remuneration incentives. In October 2019, US added Hikvision to the blacklist, which added to the uncertainty between China and US and is another concern in investing in China A shares.
The last example is Midea group, foreign investors have expressed concerns over Midea’s use their monetary fund into bank investment products. They contacted Midea's board members to raise their concerns and suggest that share repurchase instead is a common approach in the developed market. Midea took the advise and bought back 0.6 billion yuan worth of shares. This was incredible that more Chinese companies are willing to communicate with foreign investors and improve governance structure.
Based on our research, the above companies have not disclosed enough material ESG data, sourced from publicly available information. Following the release of Hong Kong stock exchange's new ESG reporting compliance requirement, all Hong Kong stock exchange listed companies will be required to report annually on their ESG performance. This is in accordance to the detailed requirement set by the Hong Kong stock exchange, commencing in financial year 2020. Rumour has it, the Shanghai and Shenzhen stock exchange will release a similar reporting guidance sometime in 2020. It's likely that the quality of ESG data disclosure will continue to improve in 2020, in anticipation of these new reporting requirements.
On the other hand, instead of tracking a vanilla emerging market index, more global investors are looking to build a customized ESG index such as emerging market ESG index or China ESG index. Chinese funds, such as JS Fund, E fund, have since launched China ESG indices.
(Written by Yiwen He, edited by Lena Chen)
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