China Forum

December 12, 2007

 

China, China, China: It’s all investors want to talk about these days. And no surprise: The Chinese economy—and the Chinese stock market—are booming. GDP growth is humming along at 10+ percent a year, and Chinese equity indexes are rising faster than the Nasdaq in the days of eToys and Kozmo.com (except this time, the underlying companies are actually making profits).

The China boom presents a unique challenge for indexers, and particularly for fans of market-cap-weighted indexing. China is now the fourth-largest economy in the world, but because the vast majority of Chinese equity shares are inaccessible to foreign investors, the country holds very little weight in free-float-adjusted market capitalization indexes: about 1-to-1.5 percent, depending on the index. That means investors who follow a free-float methodology are putting more money into Holland than they are into China. Does that make any sense?

To find out, the Journal of Indexes' editorial staff asked nine leading experts on China three questions:

1) Is China underweighted in global benchmarks, and should investors increase their exposure?
2) Is the Chinese equity market a bubble ... and will it pop?
3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?

Rob Arnott, Chairman and Founder, Research Affiliates
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
Yes, it is underweighted in global benchmarks, but that does not necessarily mean that one should increase their allocation. I am not a believer in efficient markets, and China has become very expensive by world standards. So my personal view is that China is expensive; that it is not priced to have superior returns in the coming five years; but that as part of a benchmark, it is underweight because of the benchmark’s reliance on the market capitalization of stocks that one can buy as a foreign investor.

The RAFI Fundamental Indexes weight stocks by their fundamental footprint in the world economy, not by the market capitalization that is available for foreign investors to buy. As a result, the Fundamental Index has been overweight China within emerging markets throughout its history. But interestingly, as Chinese stocks have soared recently, the Fundamental Index has been trimming back its allocation to China to return back to the fundamental footprint of those companies. At this point [November 15, 2007], the Fundamental Index is very close to the cap-weighted index for China. A year ago it was starkly overweight.

2) Is the Chinese equity market a bubble ... and will it pop?
I’m very hesitant to label it a bubble. These are big, successful and profitable companies. China is a quintessential capitalist economy at this stage, albeit one with less rule of law. As a consequence, it has less protection for external investors than we might like.

The prices at this stage relative to fundamental value are marginally above other emerging markets. I would not call it a bubble, but I would call it expensive.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
The prospects relative to the rest of the emerging markets are probably slightly below average. The emerging markets in general are fairly expensive.

James Rogers, co-founder of the Quantum Fund and author of the forthcoming book, A Bull In China: Investing Profitably In The World’s Greatest Market
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
Of course. It is one of the largest economies and markets in the world.

2) Is the Chinese equity market a bubble ... and will it pop?
It is an incipient bubble and will turn into one within a few months unless something causes a significant correction soon.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
If a full-fledged bubble develops, it will be one of the worst. If something causes a significant correction, it will be one of the best.

John Prestbo, Editor and Executive Director, Dow Jones Indexes
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
I don’t think so. I think it’s weighted just about right. China is a funny situation because a lot of the stocks are in Hong Kong, listed as Red Chips or H Shares, so if you’re using a benchmark that includes Hong Kong and the Red Chips, you’re getting blue-chip exposure to China right there.

2) Is the Chinese equity market a bubble ... and will it pop?
I wouldn’t call it a bubble necessarily, but I do think there’s a lot of Olympics enthusiasm in the market right now. Whether it pops or just deflates at some point remains to be seen. China is a developing, emerging market that is growing like the dickens, but it is still volatile. I think any investor wanting exposure to China has got to think “emerging markets” and not “developed markets.” No one should confuse China’s tremendous growth economically with economic stability.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
I think stock markets always follow economic growth and strength, and there’s no end in sight for the growth of China’s economy and its influence in the world. So my feeling is that over the long haul, China’s market is going to be going up.

Mark Makepeace, Chief Executive, FTSE Group
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
It is true that today China only makes up 1 percent of global benchmarks. The reason for this is that the main bulk of Chinese companies are listed as A Shares on the Shanghai and Shenzhen stock exchanges. Include these companies at their full market weighting and China represents almost 5 percent of the FTSE All-World Index and 32 percent of emerging markets excluding Korea and Taiwan. But even this number underrepresents the importance of China, as today many large Chinese companies have yet to come to the market to make their initial public offering.

But for now, exposure to the larger China A-Share market is restricted and likely to remain so, as long as capital controls and restrictions exist with regard to institutional investment in China. The only way for international investors to access this high-performing market is through a CSFA-run Qualified Foreign Institutional Investor (QFII) scheme. Currently there is an approximate $10 billion USD QFII quota, and reportedly, that number is soon to be increased to $30 billion. Until the quota is raised, and other issues are addressed (such as unrestricted or low restriction on foreign investment, free flow of foreign exchange into and out of China and other markets, regulatory and infrastructure issues), institutional investors will be unable to freely increase their direct exposure to the China A-Share market.

So, in the meantime, increasing exposure to China is restricted. FTSE offers three routes: Invest in Hong Kong-listed Chinese companies through the iShares FTSE/Xinhua China 25 Index ETF; invest in the A-Share market through the iShares FTSE/Xinhua A50 Index ETF listed in Hong Kong; or use our FTSE All-World Watch List indexes, which include A Shares for those investors who can secure QFII allocations.

2) Is the Chinese equity market a bubble ... and will it pop?
The A-Share market is today overvalued relative to Chinese shares listed outside of mainland China, and at some stage, this must change. But the relative overvaluation is largely a reflection of the investment controls in place, and as these are gradually removed, the valuations should realign themselves.

However, the underlying China economic fundamentals appear to be strong. This includes a growing GDP for the last four years (10.4 percent this past year), approximately $2.5 trillion in savings and a large amount of foreign reserves ($1.3 trillion). China stocks, both international and domestic, are still rising. The FTSE China Index (comprising Red Chips and H Shares) was the best-performing country index in the FTSE Global Equity Index Series last month in both dollar and local currency, up 19.5 percent. The top-three-performing stocks from the 2,500 stock universe were also Chinese: China Eastern Airlines (H), Zijin Mining Group (H) and Hong Kong Exchanges and Clearing. The domestic A-Share market is also performing well, with new listings and continued growth. Mining, Mobile Telecommunications and Life Assurance were top-performing sectors in September, with individual companies showing very strong growth: Shanxi Meijin Energy up 261.92 percent, while China Eastern Airlines gained 91.15 percent.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
Within the next five-10 years, China will become one of the world’s most important markets. Investment controls will gradually be removed and Chinese companies will adopt international practices as they seek to attract foreign investment and grow their businesses outside of China.

Today, within the global benchmark, there are already two Chinese companies (Petrochina “H” and China Mobile) in the top 10 companies ranked by market capitalization. If restrictions were relaxed and A-Shares were included in your global benchmark, the number of top-10 Chinese companies rises to six. In 10 years’ time, the vast majority of these top 10 will be Chinese!

Burton G. Malkiel, Chemical Bank Chairman’s Professor of Economics, Princeton University
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
Yes and yes.

2) Is the Chinese equity market a bubble ... and will it pop?
The A-Share market is very richly valued. Indeed, the same companies, such as Sinopec and China Life, sell at higher prices in the A-Share market than in the H-Share Hong Kong market and in New York, where they trade as ADRs. When China relaxes currency and other restrictions, these differences will disappear.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
I view the H-Share and N-Share (New York-listed Chinese companies) markets as attractive.

Roger Nusbaum, Financial Advisor, Your Source Financial
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
China is more and more becoming the straw that stirs the drink. China’s ascendancy/modernization is altering the supply and demand dynamics for many resources, including U.S. dollars. From an intuitive standpoint, China is underrepresented in many global benchmarks. Regardless of the pace of growth or what happens next in the Chinese capital markets, China will come to play an ever-larger role in the world economic order.

2) Is the Chinese equity market a bubble ... and will it pop?
China is at least in an investment mania. People are very quick to label many investment themes as bubbles. I tend to think of bubbles as being all-encompassing macro events. The aftermath of the tech bubble was that many markets around the globe got cut in half. If a big decline in China has the same domino effect, then it will have turned out to have been a bubble.

I don’t care about whether China is a bubble or not. For anyone with capital at risk, what matters is an assessment of the risks and rewards based on current information to make a forward-looking decision of how much, if any, exposure to have.

I invested personally and for clients through Petrochina (PTR) early on and then with Sinopec (SNP) for several years, until selling in the second quarter of 2007, after what I thought was a huge run. Since that time, all things China have gone much higher; there have been many new IPOs; there are many Chinese stocks with huge market caps; and the recent decline does not seem to be worrying too many people.

These are all indications of potential excess reminiscent of the tech bubble, so a sharp decline in China should not be a shock if it occurs.

Year-to-date the Shanghai Composite is up 100 percent and the Hang Seng Index is up 40 percent, while some of the bigger Chinese ADRs are up like amounts. As great as those numbers are, similar numbers have been available in other emerging markets that get far less attention; for example, the iShares MSCI Brazil ETF (EWZ) is up 80 percent year-to-date.

Although China may be underrepresented in global benchmarks, that does not mean the shares are not overvalued. That so many Chinese companies have market caps greater than $100 billion is problematic. During the tech bubble, we saw the same thing; dozens of companies larger than $100 billion, many of which are now gone or have become micro-caps.

For the time being, China is a market I want to avoid for a couple of years, until the current mania ends.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
I have no doubt that China will become more important in every aspect we could think of. Over long periods of time, and into the future, there is no question that China will be an increasingly important investment destination.

The notion of this being the China century rings very true to me. Just as the last century was the U.S.’ century, there were long periods of time where the best thing would have been to avoid U.S. equity exposure. It is only logical that now, in the China century, there will be periods of time where the best thing to do will be to avoid China for a couple of years. I believe this is one of those times.

George R. Hoguet, Global Investment Strategist, State Street Global Advisors
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
Investability is a key concept in benchmark construction and, in this sense, China’s current weight in most major benchmarks (roughly 1.5 percent) is appropriate, as it reflects what an investor can actually buy.

So far, QFII allocations for access to the A-Share market have been modest. To the extent these increase significantly, index providers should consider methods to incorporate this development into their calculations. Investors should consider benchmark weights in a “greater China” context. Hong Kong, Taiwan and Singapore all benefit tremendously from China’s growth and are truly investable.

China represents not just a global supply shock but also a global demand shock. The increasing importance of China, which in five years will surpass Japan as the world’s second-largest economy, and the BRICs in general, gives additional impetus to considering adopting a global benchmark. A “world market weighting” in China—and greater China—is a good place to start thinking about one’s strategic allocation. China is the largest emerging market in terms of investable capitalization. Investors should consider investing in China both directly and indirectly through allocations to emerging markets and global multinationals.

2) Is the Chinese equity market a bubble ... and will it pop?
One has to make a distinction between the A-Share market and the H-Share market. The former currently sells at 37 times forward 12-month earnings and the latter at 24 times.

A-Share earnings are growing at roughly 25 percent per annum; forecast 12-month earnings for investable China indexes, which include H-Shares, are growing at roughly 20 percent. A Shares represent a modest proportion of household wealth in China. Valuations in China are below the Nikkei in the 1980s and the Nasdaq in the 1990s. The A-Share market could be supported for some time by continued withdrawal by Chinese retail investors from banks. On the other hand, China continues to be in a tightening mode, and a greater-than-anticipated slowdown could lead to a rapid change in sentiment and sharp decline.

The H-Share market likely will be supported by capital outflows from China and appreciation of the Chinese renminbi, although of course global systematic factors will impact valuations.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
Global investors need to reflect on China’s growing impact on the world economy and its implications for the structure of world output and investment returns. China faces enormous environmental, social and political challenges, and investors need to make a core judgment on whether they think globalization is irreversible. Over time, China will likely progressively dismantle capital controls, appreciate the renminbi and strengthen its institutions. Like Japan in the 1960s, the Chinese economy will likely grow at least in the high single digits for many years to come, and the stock market will become more of a “core holding” for global investors. China can offer diversification benefits to a global portfolio, and holds out the prospect of return enhancement based on continued strong earnings growth. However, investors need to pay careful attention to entry-point valuations and individual company earnings prospects.

Richard Gao, Portfolio Manager, Matthews China Fund
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
I think China is no doubt underweighted in global benchmarks, and this will change significantly in the next three-to-five years as the country’s stock market is expanding very rapidly. China accounts for more than 15 percent of the global economy on a purchasing-power-parity basis and has been one of the fastest-growing major economies in the world in the past decade. Investors with a long-term investment horizon should benefit from China’s growth.

2) Is the Chinese equity market a bubble ... and will it pop?
I won’t describe the Chinese equity market as a “bubble,” but it definitely needs a correction and will be very volatile in the near term. China’s overall economy is still quite healthy, and corporate earnings growth has been strong. But the stock market has kept reaching historical high levels with record-high valuations. The domestic A-Share market was driven by huge liquidities and dominated by speculative retail investors. I won’t be surprised to see a sharp correction from here.

3) How do you view China’s prospects over the next 5-10 years relative to the rest of the market?
I am quite positive on China on a long-term prospective. Although China is already one of the largest economies in the world, it is still a poor country in terms of per capita income, and there are lots of investment opportunities as the country continues to grow rapidly and people’s living standards continue to improve. China has been consistently reforming itself and changing from a socialist economy to a market economy and has made impressive achievements. Going forward, China will be relying less on exports and investments and the economy will be more driven by domestic consumption.

Steven Schoenfeld, Chief Investment Officer, Global Quantitative Management, Northern Trust Global Investments
1) Is China underweighted in global benchmarks, and should investors increase their exposure?
Global equity benchmarks are designed to present an accurate view of the investable universe, and thus cannot include the large segment of the Chinese market which is greatly restricted to foreign investors (the A Share market). Thus, the relatively low weighting reflects current realities, and will inevitably adjust as Chinese authorities open up their market. We have seen this before with both Korea and Taiwan, and will likely see it later this decade with Vietnam. Investors can consider a “tilt” in their weightings toward China, or could consider a portfolio of “China-linked” markets such as Hong Kong and Taiwan. Another way to approach the market is to look at the H-Share market in Hong Kong (which is highly represented in most China indexes), as this class of shares will ultimately converge with A-Share prices. A pure measure of this component of the Chinese market is the Hang Seng China Enterprises Index (HSCEI).

2) Is the Chinese equity market a bubble ... and will it pop?
It has all the “necessary ingredients” of a bubbleeye-popping valuations, huge public participation, a hot initial public offering market and a very powerful macro thesis on why the valuations and bull market are justified (not to mention the excitement of the upcoming 2008 Olympics as well). The challenge is that the economic fundamentals are genuinely strong, and like Japan and Taiwan in the 1980s and 1990s respectively, the economic achievements are real.

But the signs of excess are unmistakable (including massive public speculation and excitement about the market). So the question really isn’t whether it’s a bubble, but “when will it pop?” This could even occur before the Olympics, as many local investors may anticipate a government tightening of monetary policy.

3) How do you view China’s prospectus over the next 5-10 years relative to the rest of the market?
Despite the significant short- and medium-term risks of a major correction, after my most recent visit to China in October, I am convinced that the long-term macroeconomic basis of the bull run in Chinese equities is real, and that in the long term—say by 2020—China will have substantially outperformed major developed equity markets, and perhaps most emerging markets as well. It is not unreasonable to predict that a unified Chinese market (A+B+H Shares) will comprise more than 25 percent or more of the world equity benchmarks by that time.

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