Globalization of China A-shares - Are You Ready? November 2020 - Asia-Pacific Research ...

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Globalization of China A-shares - Are You Ready? November 2020 - Asia-Pacific Research ...
Globalization of China A-shares
        Are You Ready?

         November 2020

          (11th Edition)

Globalization of China A-shares - Are You Ready? November 2020 - Asia-Pacific Research ...
About the Author

Qi Wang, CFA                               
Qi is the co-founder and CEO of MegaTrust Investment (HK), part of a research-
driven, boutique manager specializing in China A-shares. MegaTrust Investments was
founded in Shanghai in 2007 and has around US$700 million of AUM as of November
2020, with over 12 years of historical Alpha generation.
Prior to joining MegaTrust, Qi was the Head of China Index Research at MSCI, a
global index and analytics solutions provider. He advised the world’s leading asset
owners on global investing, asset allocation, portfolio construction, and risk analysis.
He also led the research and consultation on China A-share index inclusion.
Qi has over 23 years of research and investment experience, starting as a Financial Analyst in the Global
Investment Research Department of Goldman Sachs in New York. He later joined UBS and co-founded the
firm’s Global Tech Strategy Group. He was then hired by global hedge fund manager Elliott Advisors to run its
fundamental long-short strategy in Asia. Following Elliott, Qi became the CIO for China Everbright Limited, a
Chinese financial conglomerate in Hong Kong. Qi graduated from Dartmouth College with a degree in
electrical engineering in 1997, and Colby College with a double major in Mathematics and Computer Science
in 1996.
Globalization of China A-shares - Are You Ready? November 2020 - Asia-Pacific Research ...
What is China A-share?

   “Chinese stocks” are traded everywhere from China to Hong Kong to the U.S.
   A-shares refer to stocks listed in China on the Shanghai and the Shenzhen Stock Exchanges
 Share Class   Description                        Place of Listing   Currency   Sample Securities              Foreign Access
 A-shares      Chinese stocks listed in China,      Shanghai,         RMB       Kweichow Moutai (600519.SH)       Limited
               denominated in RMB                   Shenzhen                    Pingan Insurance (601318.SH)
 B-shares      Chinese stocks listed in China,      Shanghai,          USD      Lujiazui B (900932.SH)           Unlimited
               denominated in USD or HKD            Shenzhen           HKD      Changyu B (200869.SZ)
 H-shares      Chinese stocks listed in Hong        Hong Kong          HKD      Pingan Insurance (2318.HK)       Unlimited
               Kong under the CSRC approval                                     China Telecom (0728.HK)
 Red Chips     Chinese companies                    Hong Kong          HKD      China Mobile (0941.HK)           Unlimited
               incorporated abroad                                              Tencent (0700.HK)
 Overseas      Chinese stocks listed abroad via     New York,          USD      Baidu (BIDU)                     Unlimited
 Listed        ADR or ADS                          London etc.                  Alibaba (BABA)

   Excluding the 128 dual-listed A/H shares, there are still nearly 4000 Chinese companies that can only
    be accessed through A-shares

Second Largest Market Globally
                                                          Total Market Cap and Annual Turnover
                                                                                        Total Market Cap              Annualized Trading                   Annualized
Country / Region                             Exchanges                                    (USD billion)               Volume (USD bilion)                   Turnover
U.S.                                       NYSE + NASDAQ                                      35,682                       46,863                             131%
China A-shares                   Shanghai + Shenzhen Stock Exchange                            9,182                       25,189                             274%
Japan                                  Japan Exchange Group                                    5,664                        6,226                             110%
Europe                                        Euronext                                         4,286                        2,743                             64%
Hong Kong                            Hong Kong Stock Exchange                                  4,890                        2,737                             56%
India                                 Bombay Stock Exchange                                    1,827                        1,565                             86%

                                                                     Free Float Market Caps
                       A-shares                                  B-Shares                                  H-Shares                                  Red Chips
                   USD 4,170 billion                           USD 17 billion                            USD 529 billion                           USD 195 billion

Source: World Federation of Exchanges, Wind and MegaTrust.
Note: As of June 30, 2020. USD/RMB exchange rate = 6.607. The free float market cap of A-share companies is estimated at 40% of the total market cap. The true market turnover of
A-shares would be much higher if based on the free float market cap (as opposed to the total market cap).

Rapid Expansion Through IPOs

  328 A-share IPOs so far in 2020, raising a total of RMB 412 billion (USD 62 billion)
  Majority of the newly listed companies are in advanced industries like Healthcare and Tech

                                                        Number of A-share IPOs by Sector

     100     89                                                                                                90
                                                                                               86     85
                                                                                                           64       64
      60                                                                                                                      51
                                                                       41         40
      40             33                                                                                                  32
                                                                                         27               23
               1713        19                                                   20
      20                            1114                    1113            8                                         11
                                5            4 0 1 3    5          6                                                                         6 3 2 5
                                                                                                                                   1 0 1 0
             Consumer      Consumer          Energy    Financials      Healthcare      Industrials   Technology     Materials      Telecom   Utilities
               Disc.        Staples
                                                       2017                     2018               2019              2020 YTD

    Source: Wind. As of November 10, 2020.

Predominantly Retail Market

  Over 130 million individual investors in China
  “Retail investors” account for 30-40% of the stock ownership
  yet they contribute to more than 80% of the trading volume

                                                                       A-share Investor Composition
                                                                         As % of Float Market Cap

                                                                  Promoters / Insiders                          50%

                                                                  Retail Investors                              30%

                                                                  Domestic Institutions                         15%

                                                                  Foreign Institutions                          5%
                                                                  Source: AMAC and Sinolink, as of June 2020.

Passive Investing: A Zero-Sum Game?

 The long-term* index return of A-shares is near
  zero, despite China’s high GDP growth historically
 The high volatility and large drawdowns make the                                    Some argued that the high earnings growth in
  market extremely difficult to time                                                   China did not necessarily translate into high EPS
* “Long-term” refers to the last 10-15 years. Please refer to the Disclosures page     growth, mainly due to share dilution
regarding the use of indices.
                                                                                      We call this the “growth trap”

Low Foreign Ownership

  Extremely low foreign ownership of China A-shares compared to other markets

                                       Foreign Ownership of Domestic Stock Markets

         40%                                   36%

         20%                                                                                                    16%


                        Taiwan                Korea                 Japan                 India                 U.S.      China A-share

        Source: Various stock exchanges and MegaTrust estimates. As of September 30, 2020. Data available upon request.

Market Opening and Reform

   Perhaps the only “good news” out of the Trade War is more financial opening by China
 Date                    Event
 January 2019            Proposed a new round of QFII/RQFII reforms by merging the two systems and broadening the investment scope
 March 2019              Passed the new Foreign Investment Law which protects the intellectual property rights of foreign investments,
                         and prohibits forced technology transfers
 June 2019               Launched the Shanghai-London Stock Connect with the listing of Huatai Securities on the London Stock
 August 2019             Introduced Loan Prime Rate (LPR) for the banking sector in order to develop a more efficient, market-based
                         system for pricing loans. Foreign banks were invited to participate the rate initiation group for the first time.
 July 2019               Announced “11 Measures” to further open up the country’s financial sector, lifting / removing foreign
                         ownership limits for various financial services
 September 2019          Lifted the investment quota limit for QFII and RQFII, which had been existent for 16 years
 October 2019            Announced plans to scrap the foreign ownership limits on banks, insurance, securities brokerage and asset
                         management firms by 2020
 October 2019            Simplified the regulations of foreign banks and insurance companies to set up and conduct business in China
 May 2020                Introduced another round of QFII/RQFII reforms by removing the quota limits, among other major changes
 September 2020          Announced more QFII rule changes, including the expansion of the investment scope to more financial products
 Source: Chinese government websites.

Global Index Inclusion

   Even without the A-shares, China is already the single largest country in Emerging Markets
   MSCI and FTSE have both started the “initial inclusion” of A-shares in their EM indices

                  MSCI Emerging Markets Index                                      FTSE Russell Emerging Index
                            Others 11%                                                    Others 14%
                 Mexico 2%
                Russia 2%
                                                                              Malaysia 2%                                           China
            S. Africa 4%                                                     Thailand 2%                                           Offshore
                                                                 China       Mexico 2%
            Brazil 4%                                                                                                                38%
                                               All China        Offshore     Russia 3%                              All China
                                                                  38%      South Africa
                                               43%                             3%
           India 8%
                                                                              Brazil 5%

             Taiwan 13%                                                           India 10%
                                                                                                                         China A
                                                   China A 5%
                                   Korea 12%                                                           Taiwan 14%         6.8%
  Note: As of November 10, 2020.

Full Inclusion Simulation

   If fully included, A-shares would account for over 20% of emerging markets
   We expect $640 billion of foreign capital inflows to A-shares as a result of the full inclusion
                                                                               Assuming full
                  MSCI Emerging Markets Index                                                         FTSE Russell Emerging Index
                                                                               inclusions of
                        Others 9%
                                                                                                             Others 11%
                Mexico 2%                                                                                                              China
               Russia 2%                                          China                             Malaysia 2%
                                                                 Offshore                          Thailand 2%                        Offshore
              Brazil 3%                                                                            Mexico 2%
                                                                   32%                                                                  30%
         S. Africa 4%                                                                              Russia 2%
                                                                                                   Brazil 2%
                                                                                               South Africa
          India 7%                                                                                 4%
                                               All China                                                                  All China
                                               53%                                                India 8%
         Taiwan 11%

                                                                                                     Taiwan 11%
                     Korea 10%                         China A                                                                China A
                                                        21%                                                                    27%
  Note: Based on the pro-forma full inclusion of China A-hares as of November 10, 2020.

Fast and Furious

   From initial to full inclusion
                    Market                 Initial Inclusion Year   Full Inclusion Year   Time
                    Korea                  1992                     1998                  6 years
                    Taiwan                 1996                     2005                  9 years
                    China A-share          2018                     TBD                   3-5 years?

   Technical reasons why A-share’s final weight will be higher than expected
      •   A large number of IPOs each year
      •   Increase in free float market cap
      •   Possible relaxation of the foreign ownership limit (currently 30%)
      •   Potential outperformance of A-shares (vs. other emerging markets)
      •   Currency appreciation (vs. other emerging markets)
   Should China still be considered an “Emerging Market”?
   Will China become a standalone classification in the future?
      •   Emerging Market ex. China
      •   Asia ex. Japan ex. China

Inflows Driven by Active Allocation

   Global index inclusion is essential to but not necessary for the Globalization of A-shares
   Though MSCI/FTSE has postponed the further inclusion of A-shares, we still expect significant inflows
    in the near-term, as active managers move from under-weight to equal-weight China

  Non-Indexing                                        Active Allocation of A-shares in Emerging Markets (US billions)
  Percent in NB*                         0%                      3%                  5%               7%                                                    10%
            0%                             0                            0                           47                           98                          175
           20%                             0                           16                           67                          118                          194
           40%                             0                           36                           87                          138                          214
           60%                             0                           55                          106                          157                          234
           80%                             0                           75                          126                          177                          253
  Source: Based on the simulation by MegaTrust as of November 10, 2020. The assumptions and additional notes are as follows:
  (1) Total assets tracking the MSCI, FTSE and other emerging market indices are estimated at USD 3 trillion, of which A-share accounts for 5-7%.
  (2) The active money tracking the index is estimated at 85% of the total assets, with passive allocations accounting for the remaining 15%.
  (3) The “Non-indexing Percent in NB” refers to the percent of inflows through Stock Connect Northbound that are unrelated to indices, e.g. retail money and hedge funds etc.
  (4) Total inflows through Stock Connect North Bound since the initial inclusion is around RMB 650 billion.
  (5) USD/RMB exchange = 6.607

Are You Underinvesting in China?

   China will account for 18% of the world GDP in 2021 by IMF estimate
   Yet China accounts for just 6% of global equities according to MSCI

                              World GDP                                                 World Stock Market (ACWI)

                                   Other, 38%                                                       Other, 19%

                                                                                       France, 3%
                                                                                       U.K., 3%
        France, 3%                                                                     3%
          U.K., 3%                                                                 Japan, 7%
            5%                                                                     India, 1%

          Japan, 6%                                       U.S., 24%
                                                                                     China, 6%

              India, 3%
                                                                                                                 U.S., 58%
                           China, 18%

     Source: IMF estimates (GDP based on PPP) and MSCI. As of November 10, 2020.

Impact on the Emerging Markets Universe

  A-shares outnumber non-A-shares by 2 to 1 in the All China universe
  There are more A-shares than all other BRICS stocks combined
  A-share inclusion has increased the number of EM stocks by 50%
                         Standard Index                                        EM without
    Number of Stocks    Large + Mid Caps                                        A-shares     Additions from A-share Inclusion
    China A-shares             475                                             # of stocks    # of stocks        % change
    China Offshore             239         Communication                            84             18               21%
    China Total                714         Consumer Discretionary                  120             33               28%
    Korea                      107         Consumer Staples                        104             39               38%
    Taiwan                     87
                                           Energy                                   71             13               18%
    India                      86
                                           Financials                              206             67               33%
    Brazil                     56
                                           Health Care                              24             58              242%
    South Africa               39
    Russia                     23          Industrials                              87             74               85%
    USA                        618         Information Technology                   29             85              293%
    Japan                      320         Materials                                87             53               61%
    Asia Pac ex.Japan        1,255         Real Estate                              53             21               40%
    Frontier Markets           90          Utilities                                62             14               23%
    Emerging Markets         1,392         Total                                   927            475               51%
    Developed Markets        1,603         Source: MSCI. As of October 2020.

Declining Market Volatility
                  South Korea (60-Day Vol)                                            Taiwan (60-Day Vol)

                                                                                   China A-shares (60-Day Vol)
   Global index inclusion  rising foreign
    ownership and institutional holdings 
    lower market volatility

  Source: Wind. Based on the Kospi Index (South Korea), the TWSE Index (Taiwan),
  and the CSI 300 Index (China A-shares). Please refer to the Disclosure page
  regarding the use of indices.

Correlations of A-shares vs. Global Markets

                                Monthly Return Correlations (Dec 2014 - Oct 2020)
                                      ACWI                     EAFE                 WORLD                EM            FM          China A
ACWI                                  1.00
EAFE                                  0.97                     1.00
WORLD                                 0.89                     0.87                    1.00
Emerging Markets (EM)                 0.65                     0.66                    0.62              1.00
Frontier Markets (FM)                 1.00                     0.96                    0.85              0.64          1.00
China A                               0.45                     0.42                    0.52              0.28          0.42         1.00

                  Weekly Return Correlations of A-shares and Nasdaq (Dec 2009 - Oct 2020)
                                                  Shanghai             Shenzhen
                                                 Composite             Composite                SSE 50      CSI 1000     ChiNext
          Correlation                               0.34                 0.32                    0.34         0.26        0.24
          Downside Correlation                      0.36                 0.32                    0.33         0.29        0.29
          Source: Wind and MSCI. Please refer to the Disclosures page regarding the use of indices.

Long-term Sector Rotation

   In Korea and Taiwan, Consumer Discretionary and Financials saw the greatest reversals in relative
    performance, before and after the global index inclusion
                                    South Korea                                                                                           Taiwan
     Annualized Excess      3 Years Before                           3 Years After                    Annualized Excess                     3 Years Before            3 Years After
     Return Over Market        Inclusion                               Inclusion                      Return Over Market                       Inclusion                Inclusion
     Consumer Discretionary       0.1%                                   27.1%                        Consumer Discretionary                     -7.4%                    15.8%
     Consumer Staples             8.7%                                   -1.8%                        Consumer Staples                          -15.3%                   -10.0%
     Energy                      -2.5%                                    NA                          Energy                                       NA                       NA
     Financials                 -15.1%                                   20.3%                        Financials                                -14.2%                     5.3%
     Health Care                  9.7%                                  -53.1%                        Health Care                                  NA                       NA
     Industrials                 -8.0%                                  -44.5%                        Industrials                                -6.0%                    -7.3%
     Information Technology      -4.1%                                   -0.3%                        Information Technology                     14.6%                    -3.6%
     Materials                    1.3%                                  -10.5%                        Materials                                   4.2%                    12.9%
     Telco Service               26.7%                                   50.7%                        Telco Service                                NA                       NA
     Utilities                   11.0%                                  -18.7%                        Utilities                                    NA                       NA
  Source: MSCI. Based on the MSCI Korea Index, the MSCI Taiwan Index and the respective sector indices. For South Korea, the analysis is for the three years prior to 100% index inclusion on
  September 1, 1998, and the three years thereafter. For Taiwan, the analysis is for the three years prior to 80% index inclusion on December 1, 2000, and the three years thereafter. The
  excess return equals the annualized sector return minus the market return. Please refer to the Disclosures page regarding the use of indices.


                                                                                                                                         inclusions in global indices

     refer to the Disclosures page regarding the use of indices.
                                                                                                                                                                                                                                                                          Value / Growth Relative: Korea

                                                                                                                                                                                                                                                                                                            Style Shift Already Underway

                                                                                        similar structural change since 2014
                                                                                                                                        Both Korea and Taiwan had a notable style

                                                                                       The China A-share market is experiencing a
                                                                                                                                         switch from growth to value following their


     Source: MSCI. Based on the MSCI Korea Index, the MSCI Taiwan Index, the MSCI
     China A Onshore Index, and the respective Value and Growth sub-indices. Please



                  12/29/2001                                                                                                                                                                                   7/1/1997
                  12/29/2002                                                                                                                                                                                   2/1/1998
                  12/29/2004                                                                                                                                                                                  11/1/1999
                  12/29/2005                                                                                                                                                                                   6/1/2000
                  12/29/2007                                                                                                                                                                                   3/1/2002

                  12/29/2008                                                                                                                                                                                  10/1/2002
                  12/29/2010                                                                                                                                                                                   7/1/2004

                  12/29/2011                                                                                                                                                                                   2/1/2005
                  12/29/2013                                                                                                                                                                                  11/1/2006
                                                                                                                                                                         Value / Growth Relative: A-share

                  12/29/2015                                                                                                                                                                                   8/1/2008
                  12/29/2016                                                                                                                                                                                   3/1/2009
                  12/29/2018                                                                                                                                                                                  12/1/2010
                  12/29/2019                                                                                                                                                                                   7/1/2011
                                                                                                                                                                                                                                                                    Value / Growth Relative: Taiwan

A Paradigm Shift in China A-shares

                                                          China A-share Factor Index Performance

                Quality has the best performing factor in the last five years





               Market       Large Cap       Mid Cap        Small Cap        Value      Growth       High Dividend Yield      Min Vol        Momentum    Quality

  Return                 Market         Large Cap     Mid Cap          Small Cap     Value         Growth           HDY          Min Vol     Momentum    Quality
  Since Dec 2015         14.1%            38.4%       -27.5%            -38.7%       15.9%          9.0%           62.1%         17.6%         45.5%     144.5%
  Source: MSCI. Based on the MSCI China A Onshore Index (“Market”) and the respective sub-indices (all other). June 2015 to October 2020.

Small is Ugly?

   We think small caps overall will continue to underperform the market, as part of a long-term,
    secular shift towards more fundamentals and value-based investing

  Large Caps (CSI 300) vs. Small Caps (CSI 1000)

                                                                             CSI 300

                                                                                                              CSI 1000

  Source: Wind. As of November 10, 2019. Please refer to the Disclosures page regarding the use of indices.

Quality of Growth Issue

   We believe questionable M&As funded by dilutive share placements are commonly used by small-
    mid cap companies to produce superficially high growth… but low quality earnings
  (RMB millions except for EPS)           2013           2014           2015           2016           2017     2018     2019    2020E    CAGR
  Sales                                   3,584          5,979          8,347         12,319         15,231   23,104   28,106   36,462
  Sales Growth YoY                                        67%            40%           48%             24%     52%      22%      30%     39%
  Net Profit                               439            712             68           640             222      389     710      689
  Profit Growth YoY                                       62%           -90%          845%            -65%     75%      83%      -3%     7%
  Diluted EPS                             1.02            0.74           0.04          0.32            0.10    0.18     0.28     0.35
  EPS Growth YoY                                         -27%           -95%          700%            -69%     80%      56%      25%     -14%

   Source: Wind. Based on the reported financials and stock price of an A-share small cap company.

Our Investment Philosophy

  Invest in high quality companies at reasonable valuation with high conviction
  Quality is essentially about Sustainability



                                                Quality is about
                                      Good                           Strong Cash
                                    Corporate                      Flow & Balance
                                   Governance                           Sheet


Summary of Our Views

  The China A-share market is big and expanding
  The market is rapidly opening up to foreign investors
  We expect global index inclusion to trigger over US$640 billion of capital inflows
  Globalization of China A-shares should have a major impact on global investing
  …and also cause a paradigm shift in the local Chinese market
  Passive investing in A-shares can be a trap, a “growth trap”
  We believe in active management through fundamental research & stock picking
  Our unique Quality framework for China A-shares is key to Alpha generation

  Please contact us if you’d like to learn more about our award-winning A-share strategy

 MTI Management (HK) Limited (“the Company”), trading as MegaTrust Investment (HK), is a company incorporated in Hong Kong with limited liability. The Company
 is licensed by the Hong Kong Securities and Future Commission (SFC) to conduct Type 4 and Type 9 regulated activities, namely “Advising on Securities” and “Asset
 Management”. The Company’s licenses are subject to the following conditions: (1) The Company shall not hold client assets. The term “hold” and “client assets” are
 as defined under the Securities and Futures Ordinance (SFO). (2) The Company should only provide services to professional investors. The term “professional
 investor” is as defined by the SFO and its subsidiary legislations. This document (“the Document”) is prepared by the Company for information purpose only. It does
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 constitutes a recommendation, offer, or a solicitation of an offer to buy/sell any securities, portfolios of securities, financial products, investment schemes or trading
 strategies. This Document should not be relied on and is not a substitute for the skill, judgment and experience of the user, its management, employees, advisors
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 an account/scheme managed on behalf of its clients, in manners that may or may not be consistent with the views expressed in this Document. All market indices
 mentioned in this Document, including but not limited to the MSCI China A Index ("the Index") are unmanaged. The Index is being utilized for illustrative purposes
 only and an investor cannot invest directly the Index. The timing of transactions in a portfolio, advisory fees, transaction fees, and other management activities can
 create significant differences between the performance of the Index and an investment seeking similar or superior performance results relative to the Index.
 Investors are cautioned that no Index is directly comparable to the performance of a specific fund, since each Index has its own unique returns and volatility, and the
 Index should not be relied upon as an accurate comparison. This Document is provided to you incidentally, and any opinions expressed here are subject to change
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Contact Info

        Qi Wang                             王崎
        MegaTrust Investment (HK)           世誠投資(香港)
        Suite 719, Grand Millennium Plaza   香港中環皇后大道中181號
        181 Queen’s Road Central            新紀元廣場低座7樓719室
        Central, Hong Kong                  傳真: (852) 3511 6111
        Tel: (852) 3511 6023                電話: (852) 3511 6025
        Email:     電郵

        Jun Xiong                           熊俊
        MegaTrust Investments               上海世诚投资管理有限公司
        Suite 715, Citigroup Tower          中国上海陆家嘴金融贸易区
        Lujiazui Finance and Trade Zone     花园石桥路33号花旗集团大厦715室
        Shanghai, China 200120              传真:(86) 21 6887 8560
        Tel: (86) 21 6887 8556              电话:(86) 21 6887 8556
        Email:          电邮
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