Across The Border

MSCI’s China stock inclusion may prolong the decline of small-caps

Liquidity likely to start draining from Chinese small-caps next year as investors look to grab a share of those 222 stocks that will become eligible for MSCI inclusion

PUBLISHED : Tuesday, 27 June, 2017, 1:45pm
UPDATED : Tuesday, 27 June, 2017, 10:53pm

MSCI’s decision to add Chinese A-shares to its benchmark indexes – hailed by regulators and local investors as a historic moment for the nation’s US$7 trillion equity market – has, however, dealt a serious blow to the outlook of smaller growth companies.

Liquidity is likely to start draining from Chinese small-caps next year as investors look to grab a share of those 222 stocks, mostly companies with large market values, that will become eligible for MSCI inclusion.

The turnover of these 222 corporate big guns accounted for almost 30 per cent of the combined trading value of the mainland’s exchanges, when MSCI made the announcement last Wednesday.

That probably leaves trading in the sector too crowded, and the remaining 3,000-plus stocks listed in China marginalised.

MSCI’s entry was touted as a step towards bringing the world’s largest stock market only next to the US in being integrated globally.

But investors’ inevitable receding interest in the nation’s small-caps – most of which are in the service and technology industries – may be a setback for President Xi Jinping’s ambition of making the economy more reliant on consumption.

The ChiNext Index, China’s Nasdaq-style board of growth enterprises, considered as a proxy for so-called new-economy companies, is now trading close to a 28-month low, with turnover remaining at just only 40 per cent of its peak.

“The liquidity-draining effect on small-caps is pretty obvious, and the MSCI decision will only magnify that,” said Zhang Haidong, chief investment officer at Jinkuang Investment in Shanghai.

“They are certain on their way to bottoming out, and if that happens it will take a while for them to make a comeback.”

While China’s CSI 300 Index of major companies has climbed 3.4 per cent since MSCI said last Wednesday it will pick companies – including Industrial & Commercial Bank of China and China Ping An Insurance – to be included in its emerging-markets and global stock indexes, the ChiNext gauge has barely moved.

No ChiNext companies were chosen this time, though MSCI said it will include smaller-caps over time.

For now, though, that leaves small-caps out of the current beneficiaries, of steadily rising levels of foreign capital inflow.

Sinolink Securities and China International Capital Corp estimate as much as US$15 billion will initially flow into Chinese stock markets once MSCI inclusion is implemented in June next year.

Currently, global funds worth US$10.5 trillion track MSCI indexes for their portfolios, with US$1.6 trillion following its emerging-markets gauge.

Until now, Chinese small-caps remain speculative bets favoured by individual investors, as their relatively small proportion of free-floating stocks are subject to easy manipulation.

Retail investors contribute to about 80 per cent of trading on China’s stock markets, which can partially explain why share prices are more volatile.

MSCI’s inclusion may help curb that speculative sentiment by making the investor base more institutional and bringing investment styles more in line with global practices, according to Xue Jun, a strategist at Orient Securities.

There are investors, however, who believe new-economy growth companies will turn out to be the real eventual winners amid the backdrop of China’s economic transformation.

“It is critical to realise that the current structural transformation of the Chinese economy and society is benefiting predominantly new economy themes,” said Karine Hirn, the Hong Kong-based partner with East Capital with US$3 billion under management.

“To generate long-term outperformance, it is important to focus on the most structural trends offered by the new economy.”

Hirn tips environment protection stocks, particularly, as offering huge growth potential.

Investors have been offloading small-cap stocks after they largely led the stock market bubble of 2015.

Even though the ChiNext index is more than half the value of its all-time high, it is still 49.9 times reported earnings, almost four times the multiple of the CSI 300 Index.

While MSCI inclusion has already helped drive up mainland-traded shares – China Merchants Bank is already close to its record price – even the biggest ChiNext companies remain in the doldrums.

Shares in China Merchants, whose market cap is almost five times the size of ChiNext’s biggest company Wens Foodstuff, jumped 6.7 per cent in Shanghai last Thursday, the day after MSCI’s decision, its biggest gain since September 2015.

Sinolink Securities strategist Li Lifeng predicts ChiNext’s smaller firms may spend another six months floundering, before being able to arrest their downward trend, given that valuations of the big guns look like continuing to rise.