I’m not just referring to the last couple of years.
In work published* in the Q4 edition of the Financial Analysts Journal you’ll find this observation “.., since 1997 the market with the fastest growing economy [China, out of 43 that made up the MSCI World Country Index] has posted one of the lowest stock market annualized returns.”
Academics have noted for some time the conundrum of economies with fast growth producing mediocre returns for shareholders but until this work there’s been no consensus as to how this problem is explained. Now we know and here’s the section from the paper that gets to the meat of the matter:
United States vs. China
Allocation by stock market tends to overlook the importance of issuance/buybacks. Since 1997, however, net buybacks have been a major driver to be reckoned with in differentiating between high-performance and poorly performing stock markets. Forecasts of this key variable are beyond the scope of this article, but success in stock market allocation hinges upon a better understanding and forecasting of this key driver of relative performance. In that regard, the US and China stock markets present interesting, but different, challenges.
In the United States, fiscal reform may be a major force in the near future. Although gross buybacks of S&P 500 Index companies reached a peak of USD530 billion in 2017, Lakos-Bujas, Singh, Tamboli, Singh, Jain, and Kolanovic (2018) expect new US tax reform to increase gross buybacks by approximately 50%. Two-thirds (USD180 billion) are expected to come from the repatriation of cash from overseas, and one-third (USD90 billion) is expected from stronger earnings growth and tax cuts.
In China, three different forces are at play.
First, a wave of IPOs is expected in the near future (“America’s Public Markets Are Perking Up” 2018), and in the competition among stock exchanges, dual-class shares could be adopted [Er?] by the Hong Kong Stock Exchange to court possible prospects.
Second, in its “inclusion adjustment factor,” MSCI China has not yet fully considered the potential float of large companies (e.g., Alibaba, the world’s largest online business-to-business trading platform for small businesses), and the integration of these companies in the index will contribute to a net issuance effect.
Third, June 2018 was the beginning of a new era for MSCI China with the gradual inclusion of China A shares. The inclusion factor has been set to 5% at the beginning, but based on current valuations, China A shares could represent around 40% of MSCI China at the end of the process. The ongoing integration of China A shares will translate into a significant net issuance effect for the China index.
The onshore and offshore stock markets represent a much larger part of the economy than they did two decades ago, but China still has a long way to go to be at levels of other markets and to complete the transition from a segmented to a fully integrated market. Economic growth will be a key driver of future stock market performance, but so will net issuance for existing passive shareholders. Determining the relative performance of new entrants vis-à-vis the current incumbents will be of first importance. The China index investors have experienced in the past the impact of a few significant “lemons” (privatization IPOs of large state owned enterprises; see Table 3). Looking forward, investors need to ponder whether new entrants will prove to be “peaches.”
In short, China investors have suffered a blizzard of issuance (of poor quality companies at mostly high prices) for years. Investors in the U.S. on the other hand have faced a shortage of scrip.
The China Problem in Another Dimension
At the individual stock level I’ve warned investors for years that the big problem in China is never the demand for a product, it’s the ability of the market to satisfy and then swamp that demand with supply. It seems this same problem is what’s ailed the China stock markets all these years.
The last year in Hong Kong has been a good example. The South China Morning Post ran an article on December 24th with this headline ‘HK BRINGS FLOTATION CROWN BACK HOME’ (their all-caps). The article was written as if this was good news. Which it was for the Hong Kong Stock Exchange and the flotilla of arrangers and service providers that will have directly benefited.
For investors though whether they bought one of the mostly loss-making IPOs launched last year, or if they were invested (like me) in other stocks that had liquidity wicked-out, this hasn’t been good news.
No End In Sight?
In theory, this problem should self-correct. Eventually investors will tire of ponying up for the latest lemon, issuance will halt and markets will go up. In practice however this is unlikely to happen. Two reasons.
First, institutional investors who dominate the new issue process will continue to suck in rubes to their funds who believe China investment is a strategic imperative (which it is). These big investors though are asset gathering business models i.e. their first priority is to increase their assets under management (AUM) and they’ll continue to shoo money in to their funds despite the lack of attractive investment opportunities. This is not as it should be; but it is the way it is. These smart operators will then continue to act like fools when it comes to deploying assets.
Second, China Inc. is in the mix; and this operator is a notoriously bad capital allocator. I don’t need to dwell at length how state capitalism gums up the wheels of capital raising. All we need to know is they regularly participate or cause their agents to participate in new issues and at prices that make no long-run economic sense. A ready example of this process at sub-optimal work is the raft of smaller state-owned bank IPOs in recent years.
Darkest Before The Dawn?
For the reasons above I don’t believe this process will stop; but it may be paused from time to time and, given the appalling year China IPO takers have just had, one such pause may be in front of us.
Valuations in general for China stocks are depressed. Even the recently offloaded lemons have come down to levels rational optimists may find now deserve a merit-based second look. This represents dry-tinder for re-engagement. What’s needed now is restraint on the part of the institutional investor community.
This might be a possibility. The individuals who manage the largest blocks of discretionary investible funds in China stocks are not fools. They’ll have twigged that fighting for places on the shadow, pre-shadow and final IPO allocation roster has been mostly a losing game. Not only have they been pummeled, most recently by the likes of China Tower, Meituan Dumping [Dianping? Ed] and Xiaomi, but the valuations of existing holdings have been depressed in the process. This has all lead to terrible performance; and that will, as they are all aware, ultimately, affect AUM.
In Conclusion
China investors have suffered for many years from an over-issuance of paper. This surplus of paper has been taken up by a combination of China Inc. buying at uneconomic prices and institutional investors who’ve raised too much money with too few opportunities for profitable deployment.
China Inc. is unlikely to mend its ways but institutional investors may be persuaded, as often several punches to the face can, to just say no to overpriced and over-hyped new issues for a time.
If common sense is about to break out in the IPO markets for Chinese stocks a good year may lie ahead. If, on the other hand, the ‘strong pipeline’ referred to by Hong Kong Stock Exchange CEO Mr. Charles Li in his latest blog post turns into another year of bumper issuance long suffering China investors will find themselves suffering a while longer.
So then, a plea to Blackrock, Fidelity, HSBC, Capital and friends; China stocks’ 2019 performance is in your hands. Do us regular investors and yourselves a favor and disengage from the IPO machine, at least for a little while.
[* The paper Net Buybacks and the Seven Dwarfs by Jean-François L’Her, CFA, Tarek Masmoudi, and Ram Karthik Krishnamoorthy, CFA is available to CFA Institute Members at Net Buybacks and the Seven Dwarfs Not a Member? Ping me at nial@chinadream.asia and I’ll see if I can help]