China's Evolving Equity Capital Markets

There have been many negative media headlines recently about the collapsing stock prices of famous Chinese ADR companies and Hong Kong large caps due to a combination of regulatory uncertainty and in the case of the ADRs, potential delisting by the American authorities. Year to date the Shanghai Stock Exchange SSE 50 Index, which is an index of the fifty largest and most liquid A-share stocks listed in Shanghai, has declined 10% compared to a 20%+ increase for the SP 500. Over the past five years, the SSE 50 Index, as well as other key indices for markets in Shanghai, Hong Kong, and to a lesser extent Shenzhen, have all underperformed the S&P 500. Of major Chinese indices, the Shenzhen 100 Index (SZSE 100), which tracks the largest 100 stocks listed in Shenzhen, has evidenced some of the best performance with a return over the last five years of ~88% compared to ~105% for the S&P 500. 

This chart shows the S&P 500 versus the SSE 50 over the past five years and is not adjusted for dividends. 

This chart shows the S&P 500 versus the SZSE 100 over the past five years and is not adjusted for dividends.

This chart below shows the Hang Seng Index over the past five years. All three indices were impacted by the trade conflicts with America in 2018, but the Shanghai and Shenzhen indices have recovered while the Hang Seng index’s recovery has been hampered by the decline in the valuations of some of its top constituents over regulatory concerns, namely Meituan, Tencent, and Alibaba, among others.

Key to the SZSE 100 index’s outperformance against other Chinese indices over this time is the inclusion and top weighting of several leading Chinese companies that have produced particularly outsized returns for shareholders over the past several years, namely the index’s largest constituent: battery manufacturer Contemporary Amperex Technologies Limited (300750) as well as major liquor producer Wuliangye (000858) and electric car and contract manufacturing company, BYD (002594).

Besides the outperformance of the SZSE 100, why have other major Chinese indices lagged so much behind the S&P 500?

It’s tempting to write off Chinese indices as held back and distorted by slow growth, high dividend state owned enterprises (SOEs). While this was certainly more true in the first half of the prior decade, presently the SSE 50 top 10 constituents only include two SOEs (Industrial Bank and Citic Securities), the SZSE 100 includes one (Hikvision - 002415), and the Hang Seng Index includes one (China Construction Bank). As more and more large private companies have listed and expanded their businesses, they have displaced the SOEs that previously held top positions in the indices. 

While the SOEs certainly do have some influence on the indices, and there has been a general sell off of recent triggered by cascading fears over property developer defaults and more regulations from the authorities in Beijing, one of the major reasons that the Mainland and Hong Kong indices have underperformed the US indices is because the aggregate equity capital market is still in a comparative period of development relative to that of the US. 

The chart below displays the number of total listed companies in The US and their total market capitalization through the end of November 2021. The left axis of the chart displays the number of listed companies and the right axis the total market cap in trillions of dollars.

Presently there are nearly 6000 US listed companies and the total US equity market cap has increased substantially over the past several years as the valuations of top stocks has grown in the absence of a substantial number of new listings. 

The number of US listed companies increased by ~20% since the start of the pandemic due to the SPAC boom as well as favorable financing conditions. However, even when including this surge in listings since the start of the pandemic, between 2011 and the end of 2021, the annual growth in the number of listed companies increased at only a 2% CAGR. The rapid growth in total market capitalization is in certain respects due to a combination of tax cuts under the Trump administration, sustained low interest rates, quantitative easing, and other stimulus, which led to multiple expansion for stocks, as well as exponential increases in profits generated globally by leading American companies like Google, Amazon, and Apple, among others, that are also the largest index constituents.

By contrast the charts below display the total number of listings in Hong Kong and Mainland China respectively as well as their total market caps in HKD and CNY. Again the left axis of the charts displays the number of listed companies and the right axis the total market cap in HKD or CNY. Over the past ten year period, the number of listed companies in Hong Kong has increased at a 5.5% CAGR and the number of listed companies in the Mainland has increased by a 6.9% CAGR.

It’s interesting to note that both the charts for the Mainland and Hong Kong equity capital markets display similar trends in terms of consistent year over year increases in the number of listings and few declines in total market capitalization. Even after the Mainland stock bubble burst in 2015, total capitalization barely declined as it was buoyed by an increasing number of listed companies.  

Finally, in the same format, this chart displays the total number of listings and total market cap converted into CNY for the Mainland and Hong Kong equity markets combined over the previous ten years. During this time the number of listed companies combined increased at a 6.4% CAGR and the total market capitalization increased at a 13.5% CAGR.

Presently the US market’s total capitalization is roughly 50 trillion dollars, while Mainland China and Hong Kong together are approximately 128 trillion CNY, or 20 trillion dollars. China has over 7000 listed companies compared to about 6000 in the US. China’s central bank also has much higher interest rates (~3.8%) compared to the near zero rate of the US Federal Reserve, so Chinese equities have been comparatively less impacted by liberal monetary policy than their US counterparts. 

There are several takeaways from these comparisons of equity market growth between the US and China.

First and foremost, one of, but certainly not the only reason, that Chinese indices have been performing worse than those in The US is that with so many new listings each year, investors are selling some portion of their existing holdings to invest in the shares of new companies, thus holding down price appreciation in some of the index constituents. Chinese IPOs also tend to be priced low and enjoy substantial price appreciation after listing due to rules about how long the underwriters must hold the shares after the IPO. With so many new companies coming to market each year, there is simply more competition between new and existing issuers to attract capital. Thus, Chinese indices simply don't capture the growth of the overall equity capital market because they only display the performance of a sliver of listed companies, not the total size of the market, either by number of listings or total capitalization. 

Second, China’s financial system is still relatively new and stock trading only really became feasible in the early 1990s as both the Shanghai and Shenzhen bourses opened that year. Now there are over 180 million retail investors in China out of a population of 1.4 billion. Approximately 50% of Americans own stocks, so there is still substantial room for convergence in the number of individual investors in China. Furthermore, as the authorities in Beijing attempt to spurn property speculation and place limits on real estate investing (hopefully a property tax in the future), it’s likely that in the long term Chinese households will increase their allocations to equities, especially as the financial system continues to be reformed and a greater number of next generation companies (think Meituan, Xpeng and the like) choose to list in Hong Kong and the Shanghai Star Market, a new board for innovative companies with different trading rules (see Transsion-688036). Increasing equity allocations from domestic households, as well as greater interest from foreign investors should buoy overall equity market capitalization in both the Mainland and Hong Kong in coming years.

Finally, US GDP is approximately 21 trillion dollars and China’s GDP is approximately 15 trillion dollars, yet America’s total equity market capitalization is roughly 50 trillion dollars while the comparable figure for China is 128 trillion CNY, or 20 trillion dollars. Of course, America’s financial system is far more mature and as stated, the valuations of top American companies have been buoyed by their explosive overseas development. However, given the disparity in GDP to market cap between the two nations, it’s likely that there will be some degree of convergence over the coming years. As China’s financial system becomes more sophisticated and attracts more companies and capital, total equity market capitalization should continue to rise, both in absolute terms, and as a multiple of GDP. 

In conclusion, the evidence points to Mainland & Hong Kong capital markets being at least 1-2 decades away from maturity.