Small companies, as the heart of China’s “new economy,” capture China’s entrepreneurial spirit, while helping investors meet long-term goals for growth. For investors seeking alpha, China’s small caps may present a compelling opportunity.
As China’s economy continues to shift towards services and consumption-related industries, small- and medium-size businesses are helping to accelerate this transformation.
1. Entrepreneurial Small Companies are a big driver of China’s New Economy Growth
Small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments such as manufacturing, infrastructure and real estate, and toward innovation, consumption and services. China’s smaller companies tapping into the entrepreneurial spirit across cities and provinces tend to thrive mostly in productivity- and value-enhancing industries such as automation, health care, e-commerce and education. These areas are under-represented in large cap-oriented benchmarks and portfolios. Small-cap companies have the entrepreneurial spirit and flexibility to recognize and respond to changing local market trends, including changing patterns of consumption.
We believe China’s transition to entrepreneur-driven growth could lead to value creation and attractive investment opportunities among small caps.
2. Vast Universe of Small Companies in China today offer Investors Differentiated Exposures
China’s small-cap equity universe has expanded exponentially over the past decade to become the largest small-cap market in the world. Surpassing the U.S., there are more small companies listed, and higher average daily liquidity, in China’s accessible small-cap market than in the U.S. China provides a broad investment universe for stock pickers: more than 5,000 companies with a market capitalization of less than US$5 billion, which we define to be small cap, are domiciled in China.
In particular, the Healthcare and Information Technology (IT) sectors have been one of the fastest growing sectors, offering investors a myriad of opportunities. An aging population with rising life expectancy, urbanization effects, and a rising wealth effect have fueled the demand for healthcare services. China’s population is roughly four times larger than the U.S., providing a vast market of health care consumers. Yet, the market cap of many Chinese health care companies is really in its infancy when compared to the U.S.
3. China Small Companies – Small Caps Appear Poised to Re-Rate on Strong Earnings Growth and Low Valuations
While the supply of new companies available to invest in has expanded, demand from foreign investors has been slow to develop over the past five years ended September 2019. This mismatch of supply and demand of China’s small-cap stocks has resulted in low valuations and weak overall stock returns during this time. The composition of China’s overall equity markets is changing as foreign institutional investors start to increase their allocations to China.
China’s small companies currently have higher earnings growth than U.S. small companies, European small companies and China’s large companies. What’s more, valuations are low when compared to other small companies globally. Accordingly, we believe valuations have the potential to rise and expect the gap between small and large companies in China to narrow over time as investors take a closer look at the quality and growth trajectories of China’s small companies.
Quality metrics of many small caps in China, including high return on equity, are positive and many companies generate a solid return on their assets, together with attractive earnings-per-share growth opportunities.
Many investors today may already have exposure to China via investment strategies tilted toward larger companies. For investors specifically looking to access China’s dynamic growth potential, adding exposure to small companies can help complete a China allocation.
For non-Hong Kong based readers – Contact a Matthews Asia representative here for more information about Small Caps in China and the Matthews China Small Companies Fund
For Hong Kong based readers – Contact a Matthews Asia representative here for more information about Small Caps in China and the Matthews China Small Companies Fund
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