Potential gains to be found beyond China’s mega-caps

July 06, 2021 10:41
Though China’s international borders remain shut, domestic air travel and tourism have rebounded strongly. Photo: Reuters

China’s early and sustained economic recovery from the coronavirus pandemic was reflected in a strong performance last year. However, many might be surprised to learn that 50% of Chinese stocks actually fell in 2020. In particular, large-cap stocks outperformed small-caps by 7.33% last year.

Moving into 2021, as the economic recovery broadens out and liquidity becomes tighter, the wide valuation divergence we saw last year could potentially normalise, especially for some of the more crowded growth names and thematic stocks. As China’s stock market transitions from being liquidity-driven to earnings‑driven this year, stock selection will be paramount.

A year of normalization

2021 is a year of normalization for China’s GDP, earnings growth, financial markets and policy after the preceding pandemic disruption. As the economy recovers, we expect the Chinese consumer to play a bigger role this year, thanks to pent‑up demand. Successive holidays and festivals have been accompanied by improving consumer confidence. Residential property, one of the first sectors to recover, remains well supported. Sectors exposed to developed markets economic recoveries might also benefit, as well as export manufacturers leveraged to global trade.

We believe the COVID‑19 vaccination rollout should facilitate a further rebound in those business and consumer services that have been lagging, such as food, hotels, entertainment, and personal services. Though the country’s international borders remain shut, domestic air travel and tourism have rebounded strongly. During the Labor Day holidays in early May, the number of domestic tourist trips reached a record 230 million, 3.0% more than in 2019 . As China ramps up its vaccination program, we should see a more visible path for opening international borders in 2022.

Structural change creates new opportunities

A key focus of the National People’s Congress’s five‑year economic plan (2021–2026) is President Xi Jinping’s “dual circulation” theory. This seeks higher‑quality growth through supporting domestic markets, innovation, and reform. Beijing views boosting domestic demand, upgrading supply chains, and achieving greater self‑sufficiency in key technologies as the best ways to hedge against external uncertainties and challenges.

Innovation is becoming the key driving force for policymakers. Beijing is looking to actively shift its competitive advantage away from a labor-intensive model to one more focused on engineering abilities. This is being helped by an increasingly educated workforce. While China’s demographic dividend is coming to an end, education is taking up the slack with approximately 1 million college students graduating every year.

China also has plans to transition to clean energy and reduce net carbon emissions to zero by 2060. Its efforts will likely contribute meaningfully to global carbon reduction, with a sharp focus on renewable sources of energy. A future that is driven by renewable sources of energy could allow China to become more self‑sufficient and less dependent on energy imports.

Given the speed of change and the inefficiencies that present themselves in the market, we believe China remains a fertile ground for good stock selection. There are pockets of speculative bubbles, such as in some thematic stocks, but we are still able to find attractive opportunities in the supply chains that support these industries. The transition away from a carbon‑intensive economy to a more sustainable economy offers a tailwind to industrialization, and we are finding relatively attractive value in some industrial businesses.

We see consumption as another important pillar of growth, from the government’s perspective, with a focus on quality growth. These tend to be companies that offer compounding growth opportunities as well as some companies that are undergoing a positive product cycle. The shift of domestic demand from foreign brands to local brands provides another tailwind. With this favorable backdrop, we believe homegrown businesses can take a step further and potentially expand to become global leaders.

Identifying the rising stars beyond mega-cap stocks

China has over 5,200 listed companies and offers a huge opportunity set available to investors. However, while the top 100 mega‑cap stocks only represent 2% of the total Chinese universe , they account for roughly 70% of the MSCI China Index and are widely owned by local and foreign investors. We believe the remaining 98% of the Chinese universe, which is under-explored, is where investors can find mispriced opportunities and potential hidden gems.

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Portfolio Manager of T. Rowe Price’s China Evolution Equity Strategy