A number of factors have recently led us to take a closer look at the Chinese equity market.
First, the Stock Connect scheme that will allow mutual market access between H shares listed in Hong Kong and A shares listed in Shanghai is a hugely significant development.
Following on from smaller steps in the form of QFII and RQFII licences and part of a wider financial reform programme, the opening up of investment into mainland Chinese companies is a big step.
The opportunity is a clear signal China is serious about welcoming foreign investment in its equities, and the Chinese and Hong Kong markets when summed together would be the second largest in the world after the US.
It is likely the market would enter the major Global and GEM indices, depending upon the rules of the index providers, in either 2015 or 2016. For example, the weight could become as much as 30 per cent of the MSCI GEM index.
Second, Chinese equities are essentially flat on their level of three years ago, yet earnings per share have almost doubled.
Finally, the Chinese market appears optically cheap on a price-to-earnings ratio of less than nine times, compared with a seven-year average of more than 11 times.
As fund selectors, we have to delve into these details and ascertain if it is worth adding exposure to China and which manager we should invest with.
Looking at market valuations with banks included and excluded, a contrasting picture results.
The MSCI China index is well above its long-term average at 14 times if Chinese banks are excluded. Banks are cheap because the majority of investors are sceptical about the shadow banking sector, the growing levels of indebtedness and the realism of the non-performing loans reported.
Perhaps the stocks that one wants to own are already at full valuations. There are a huge number of A shares and many of them are state-owned enterprises (SOEs).
The importance of shareholders to them is questionable. Many Chinese investors are said to be short-termist and not overly focused on fundamentals.
The A shares market consists of more than 2,500 companies and is relatively inefficient, so there are rich rewards to be had for those managers who can navigate this space successfully.
For these reasons, it is important to consider investing in non-SOEs and taking a long-term perspective. Some stocks have a dual listing such that they are quoted on both the Hong Kong exchange and Shanghai exchange.
While there used to be opportunities to exploit the pricing discrepancies between the two listings of the same stock, these gaps have mostly disappeared – to single-digit percentages – as arbitrageurs have acted ahead of the Stock Connect scheme going live.
As always, fund selection is key, especially in a region as unfamiliar as China.
Ian Aylward is head of multi-manager research at Aviva Investors
