Macroscope | Why China’s economic success is no bellwether for foreign investors in Chinese stocks

China’s economic revolution has been one of the defining stories of the 21st century. Yet, for foreign investors in Chinese stocks, the returns have been far less impressive.

This is a stark reminder that equity investors buy companies, not economies. High economic growth may create an environment that is conducive to higher revenue growth, which in turn can contribute to increased earnings growth across the corporate sector – but this is not necessarily the case.

Much of the divergence between China’s economic and stock market returns can be explained by the composition of equity indices. Many of the first major Chinese companies which listed overseas, as represented by the Hang Seng China Enterprises Index, were state-owned enterprises whose primary focus was building domestic Chinese infrastructure. The other key listings were the state-owned banks, which now dominate the index.

Despite the more recent emergence of China’s internet giants, the MSCI China index remains quite narrow, with information technology businesses and financials comprising fully 60 per cent.

The onshore A-share index offers a wider choice beyond information technology and financials and has greater exposure to mid- and small-cap companies. It is also both broad and liquid, offering a wide range of equities for investors. Indeed, at the end of 2017, the A-share market contained more stocks with more than US$10 million in daily liquidity than all other emerging markets combined.

The A-share market is diversified by sector. The expanding middle class is both supporting and demanding an increasingly sophisticated set of consumer goods; for example, in beverages and fashion. The power of domestic brands is increasing. Chinese companies are moving up the technology curve from lower margin commoditised goods to higher-value areas such as handset components and software services. In some cases, China is pursuing its own business models; in payment systems, areas of gaming and financial technology, for example.