Yes, China is investable for patient investors

What happened

Didi’s departure from the U.S.

On 23 May, Didi Global (the Chinese ride-hailing company) got approval from the shareholders for its "voluntary" delisting from the NYSE. The Chinese authorities mired the company in a series of cybersecurity investigations following its "unauthorized" IPO less than six months ago. Didi mentioned that a delisting was necessary to complete its ongoing cybersecurity review. As of now, it remains unclear what punishments the company will face from this IPO without Beijing's blessing.

Since the blockbuster IPO, its price had plummeted 87%, wiping out more than $58 billion in market value. The delisting announcement is a stark reminder of the hot debate currently raging among global investors: is China still investable considering its policy-controlled nature?

The short answer is yes, and here is why. 

Impact on our Investment Case

Countdown to Delisting

In March, the SEC announced the first batch of as many as 250 Chinese companies that will face delisting if they fail to provide detailed audit documents for 3 consecutive years to support their financial results. As of now, the SEC has provisionally listed 80+ China-based companies, including big names like Alibaba, Baidu and Nio, and delistings could happen as soon as 2024.

The regulator’s move is backed by the Holding Foreign Companies Accountable Act passed in 2020 after the Chinese coffee brand Luckin Coffee admitted to committing accounting fraud by inflating its revenue by $300mn. The act empowers the watchdog Public Company Accounting Oversight Board (PCAOB) to review the financial audits and requires public companies to declare if they are owned or controlled by any foreign governmental entity.

At the beginning, the Chinese government refused the U.S. audit inspections into the work of China-based accountants and forbade Chinese auditors from making certain disclosures to foreign regulators. Until recently, the Chinese authorities have shown a willingness to reach a deal with PCAOB and have drafted a framework to provide clarity on what kind of data may fall into the “categories”(involving the national security issue) as Didi did due to its wide and precise data on users, mapping and traffic. However, negotiations between Beijing and Washington are still ongoing and a mutual agreement is not guaranteed. In any case, should the relevant Chinese authorities wish, they can effectuate the voluntary delisting of any China-based company that falls into the spectrum of “too sensitive to comply” with PCAOB. In addition, given the geopolitical issues at stake, the situation would appear to be quite complicated.  

China is growing at a sustained pace

Over the past two decades, China’s economy has outpaced all major economies growing at a CAGR of 13% (2001-2021) to become the second-largest economy in the world, accounting for 18% of the world’s GDP and ~15% of global production.

Its recent economic slowdowns have frightened many foreign investors. China slowed from double-digit growth 10 years ago to 4-5% now. During the Covid-19 outbreak, it even dipped to +2.2% (the U.S and European economies shrank -3.4% and -6.4%, respectively). However, even with a “disappointing” 3-4% growth per year, by 2026 its economy will reach $21.5tn, adding the equivalent of the entire UK's economy ($3.1tn). 

As its government has prioritized sustainable and socially responsible growth, China is undergoing profound changes in its economic and political structure (especially as this autumn Xi is expected to secure his third and life-long mandate). These changes are deemed necessary for securing long-term prosperity over the next decades.

Despite current challenges such as strict Covid-19 policy and geopolitical issues posing uncertainty to near-term growth, the fundamentals of the economy and investment prospects in the long term haven’t changed.

Investing in China is not child’s play

Investing in a developing country is never easy; however, the rewards are significant. It is all about finding the sweet spot where macro policies and investment value come cross, and investing in China is no exception. Investors must understand how bureaucracy's politics in China is drastically different from the Western system. For example, when vice-premier Liu He (who led the Financial Stability and Development Committee) stressed that the government will “actively release policies favorable to markets”, it was an important signal. The Committee under China’s State Council supervises the central bank and the securities regulator, in contrast to the U.S. where the Fed is independent of government influence. Hence, the central bank has to execute monetary policies accordingly. In addition, The People's Bank of China is also “relatively quiet” in its communication with the public compared to its Western peers. Similarly, the reports presented to the top management of the Communist Party can at times weigh more than ones released by the securities regulator.

Therefore the challenge for investors is not only to be trending-sector savvy but also to be able to decipher signals between strategic policy developments and latent regulations.

Active managers can capture alpha opportunities in China

Currently, there are two ways for foreign investors to directly access the Chinese mainland stock markets (Shenzhen Stock Exchange and Shanghai Stock Exchange): through either the onshore Qualified Foreign Institutional Investor scheme (QFII) or the offshore Stock Connect program. Although each scheme has loosened its requirements and has been expanded several times since its launch, tighter restrictions than other developed markets still apply.

For example, under QFII, foreign investors are required to entrust a local QFII custodian to apply for the QFII license with China Securities Regulatory Commission (CSRC) and register with the State Administration of Foreign Exchange (SAFE). The whole process might take nearly 3 months, depending on how long the KYC as well as the onboarding procedures take to be completed and how restrictive the COVID situation is.

Thanks to the limited access to offshore investors and the dominance of retail investors (70%+) in terms of volume, the A-share market may well be the only major market where active investors can harness Alpha from market inefficiencies.

According to Morningstar, “76% of actively managed Chinese stock funds available to Chinese investors managed to both survive and outperform their average passive peer over the prior decade. On the other hand, just 19% of actively managed U.S. stock funds can claim the same over the 10 years through June 2021.” Inefficiency in the Chinese onshore market creates mispricing opportunities for investors who do their homework. The breadth, liquidity, and depth of the Chinese stock market make active equity investments benefit from smart stock selection.

As the China A-share market becomes more accessible to foreign investors – transitioning from being retail-led towards more institutionalization – the window of opportunity to capture strong alpha may fast disappear. That means investors who are early movers and have experience can find attractive targets that pay back the hard work.

We believe that – given its long-term economic growth outlook and the market inefficiencies awaiting discovery (especially when hedge fund penetration is still low) – a sophisticated, active manager can harvest significant alpha in the Chinese equity market.

Source: Bloomberg

A China growth strategy offers the best diversification (lowest correlation)

A global equity portfolio will enhance its risk-returns profile by adding a China component, thanks to its low correlation with global markets.

The rising correlation between DM and EM equities (for example, the correlation between MSCI World and MSCI EM Asia is up to 0.8) has deteriorated the diversification effect of emerging market investing. However, China still maintains a weak association with global equities due to its limited market accessibility and unique economic and political considerations. A low correlation means global investors could improve the risk-adjusted returns and may reduce overall portfolio risks by simply including China shares.

China shares have a low correlation with global markets.  

March 2019~March 2022, monthly data

Source: MSCI, AtonRâ Partners

The longer the holding, the better the effects of diversification!!

Last but not least, a medium-term holding period (ideally 3+ years) can further enhance the effectiveness of diversification across regions for a global portfolio.  

When analyzing different regions (the U.S., developed EMEA, developed Pacific, and EM) and holding duration (from 1-36 months), we see that global investors whose holding period is longer tend to enjoy a higher diversification effect.

According to MSCI, the chart shows the average pairwise correlation among North America, EMEA, Pacific, and Emerging Market regions for different holding periods from Dec. 30, 1994 to Nov. 30, 2020.

Source: MSCI

Our Takeaway

Many global investors have overlooked the strategic role of investing in China. Adding Chinese equities to a global equity portfolio provides diversification benefits and better captures long-term economic growth opportunities in a supplementing role. Investing in China, as investors do with emerging market investments, due diligence and agility are key, and an active investment approach is essential.

China may experience ups and downs in the short term as each market does (or even has higher volatility due to the geopolitical uncertainty and the COVID-19 situation), but as a long-term investor who strives to capture the structural trends, we remain confident in the Chinese equity market. China aims to be self-reliant, pursuing its own transformative path to differentiate itself from the Western world. Its markets are highly driven by policy that often weights higher than the value of individual companies, and its policy remains here to support innovation-led growth.

At atonra, our total exposure to the Chinese economy remains above 10%, and we have switched all of our ADR holdings to A and H shares to reduce systemic risk (delisting risk) for our investors. We continue to believe that investing in a sustainable and more balanced Chinese growth should yield healthy rewards for investors who have vision and patience.