How successful has the launch of the stock connect programme proved?
First, I should point out that there are actually two separate programmes in China, connecting both the Shanghai and Shenzhen exchanges to trading in Hong Kong. Shanghai Connect was launched in 2014 with its Shenzhen equivalent following in Q4 of last year. The former proved an instant hit with overseas investors exhausting their RMB 13 billion daily quota well before the end of the debut session. In contrast, the latter got off to a very slow start, but this arguably reflected relatively higher valuations in Shenzhen and the failure of Chinese stocks to be included in key international benchmarks earlier that year. Now that MSCI has reversed its stance towards the inclusion of A shares in their indices, albeit that representation will build up slowly from a very narrow initial base, interest from international investors appears certain to accelerate.
Were you able to invest in local A shares prior to the launch of the connect programmes?
The simple answer is yes, but, of course, it was rather more complicated than it is now. Previously, the QFII programme allowed international asset managers to access the local market, but each company had to be approved separately and received an individual quota. Consequently, the majority were effectively denied access. We could also, and still do in certain cases, invest via participation notes structured by brokers.
Stock connect must have improved liquidity; how has this affected your strategy?
There has been no strategic impact at all because the portfolio is not traded particularly heavily. Since we are focusing on the evolution of the Chinese economy from manufacturing to consumer driven, the portfolio is aligned to consumption themes and trends which can be quite secular in nature, meaning that we don’t trade often. Instead we hold our stock positions as long as the businesses are moving in the right direction and valuations are fair.
How have the connect programmes changed the overall trading dynamics?
The local market has traditionally been dominated by retail investors, who are far more focused on momentum and short-term investing. Consequently, they are naturally drawn towards small caps, where the pricing action is more intense, and tend to ignore valuations. In discussions we have held with domestic managers, we are hearing increasing tendencies toward shifting their strategies to a more ‘Westernised’ approach. Where previously their style had been speculative – in effect trying to demonstrate their ability to beat retail investors at their own game – they are now becoming more attracted to blue chips. Increasing international inflows through the connect programme is likely to swing the balance further in favour of blue chips.
What is your portfolio’s approximate exposure to A shares?
Since we are focused on changes in domestic consumption, our primary sectors of interest are consumer discretionary, (consumer-related) technology and health care. A number of stocks in these areas have been listed on the Hong Kong exchange for years, so there is a dual-listing overlap, but others can only be bought in the A share market, which is the second-largest in the world behind the US. At this stage of China’s evolution, our aggregate exposure to A shares is around 8% of the portfolio, but we expect this to increase significantly over time.
How have the connect programmes impacted upon the performance of your strategy?
The increasing focus on blue chips among other market participants is unquestionably helping to push up the share price of our portfolio constituents. This is because we concentrate on unearthing the best opportunities in large cap A shares that are aligned with our overarching investment theme and trade at a discount. For an extended period, the dominance of the A share market by speculative local investors has seen small caps outperform their larger peers despite an increasing valuation gap. Conversely, as of the second week of November, year-to-date performance of the ChiNext index of high volume, high valuation stocks is actually negative, while the CSI 300 index of larger A shares is up 21%. This is a dynamic shift that, in our view, has much further to go…and relative valuations back this perspective. Currently, ChiNext is trading at a forward P/E (price/earnings ratio) of 32, while the CSI 300 remains markedly cheaper at 15.4. We expect this valuation gap to continue to close.