Robust fundamentals helping Chinese stocks outperform peers

Equity markets on the Chinese mainland have been among the best-performing in the world over the past year and indeed over longer time horizons. Yet, many foreign institutional investors have been underweight on China versus benchmark weightings in global equity indexes, such as those provided by MSCI Inc or FTSE/Xinhua.

It is important to recognize that for the longer-term investor, the key driver of performance for any equity market is growth in earnings and dividends. Here, China has a strong story to tell.

The MSCI China index, which covers China-based companies listed in Hong Kong or the United States, has recorded a compound annual growth rate of 13 percent in earnings per share over the past 10 years, expressed in dollar terms. When it comes to dividends per share, the CAGR was 11 percent, also in dollar terms. These numbers were far in excess of the averages recorded in emerging markets overall (5 percent and 6 percent, respectively).

So China's corporate sector has done a good job of translating superior economic growth into superior earnings and dividend growth. Hence, it should be no surprise that MSCI China has delivered a cumulative return of 315 percent in dollar terms over the past 10 years versus just 145 percent for the broad MSCI Emerging Markets benchmark.

Yet, foreign institutional investors have clearly been skeptical about the sustainability of this earnings and dividend growth. There is much debate over whether China will be successful in transitioning its growth model toward consumption and services, and the extent to which the economy has become overly reliant on leverage to drive growth.

This debate meant that, until recently, China equities both onshore and offshore have traded at a valuation discount to other emerging markets and global equities more generally.

For instance, this time a year ago, the MSCI China traded at a trailing price-earnings multiple of just 9.3 times, which was a 25 percent discount to global emerging markets, while the Shanghai Composite traded at 9.6 times.

That has changed recently, with a substantial re-rating of both markets. The main factor driving this change has been a resurgence of interest in equities as an investment asset class from domestic investors in China and a recent rise in southbound flows into the Hong Kong market through the Shanghai-Hong Kong Stock Connect program.

Foreign institutional investors' interest in China has also begun to improve, particularly since monetary policy easing began late last year.

The MSCI China has re-rated in trailing P/E multiple terms to 12.8 times, now broadly in line with other emerging market equities. The equivalent multiple on the Shanghai Composite has risen to 20.1 times. Both are now back at long-run average levels.

We therefore see risk versus reward in both markets looking forward as more evenly balanced than in the past. This led us recently to shift our recommendation on MSCI China for a global emerging markets investors from "overweight" to "equal weight".

Within the China market, our preferred sectors include consumer stocks, information technology and healthcare, as well as banks and insurance. These companies represent the "new economy".

We are less positive on the "old economy" sectors of energy, materials and industrials, although some opportunities exist in these sectors for companies with exposure to the Chinese government's "One Belt, One Road" initiatives.

The author is chief Asian and emerging markets strategist at Morgan Stanley. This article is not an offer to buy or sell any security/instruments or to participate in a trading strategy.