Could Chinese small-caps be a post-Covid investment winner?

by Jonathan Adams
global equities crashed

It’s just over a year since global equities crashed after a sharp sell-off in stock markets rattled by the dawning realisation a new virus first identified in Wuhan, China, was likely to cut a swathe across the world. Those fears proved founded and we’ve spent the past 12 months veering between hope, frustration, despair and successive lockdowns.

But like any ‘Black Swan’ event, the coronavirus crisis has led to business and financial markets winners and losers. Some sectors like energy, commercial property, travel, tourism, hospitality, leisure, and events have been devastated. Most companies in these sectors have been forced to shut up shop, or work under severe restrictions for much of the past year.

The predictable result has been revenues and profits for companies in the sectors worst hit falling off a cliff. For many, survival has only been possible thanks to a combination of government support and convincing investors to inject enough cash to ensure operations can resume when life returns to normality.

Other sectors saw their revenues and profits soar as a result of the changes to everyday and working life brought about by the pandemic. The technology sector, from software tools for remote communication and productivity, digitalisation of business process to ecommerce and digital entertainment, has benefitted. In fact, the pace of the tech sector’s accelerated growth has been enough to tempt investors back into equities markets, fuelling a surprising bull run on Wall Street that has been in place since the middle of last March.

Despite the international roll-out of a Covid-19 vaccination programme from the beginning of this year, it’s now apparent it will be another several months before life enters its post-coronavirus phase. But after a year of rollercoaster emotions and hopes of a quick recovery being dashed, a roadmap out of lockdown and back to normality has been enough to spark newfound investor optimism. And a change in attitudes.

The past week has seen tech stocks and other winners of the pandemic suffer a correction. On Wall Street, the tech-heavy Nasdaq shed 4.9%. Fears around the prospect of rising interest rates, sparked by an uptick in bond yields, have certainly had an impact.


Investors are now making post-pandemic bets

But so has a general feeling that even if it takes another few months before large parts of the economy full reopen, life will now start to slowly return to normal. And with it, pre-pandemic consumer and business behaviour patterns. Changes to how we spend our money that took place over the lockdowns of the past year may not fully reverse, but markets clearly think there will be a regression back towards the mean.

That’s seen investors pull money from lockdown winners over the past week, locking in profits. And they are now reinvesting in companies, sectors and geographies viewed as those likely to be among the best performers of the post-pandemic world economy.

Sectors that were lockdown losers but should start to see revenues, profits and valuations start to recover are one direction benefiting from recent changes to the flow of international investment capital. Asia, large parts of which more successfully controlled the pandemic than the USA and Europe, is another beneficiary. Better management of the spread of the virus saw Asian economies such as those of China, Hong Kong, Japan, Singapore, Taiwan, and Kuala Lumpur reopen quickly then largely stay open.

There was already a shift of global economic power from west to east in place pre-pandemic. Many economists and investors believe the hit to the traditionally big, advanced western economies, combined with the relatively much smaller impact on rising Asian economies, will accelerate that process.

China and Japan’s stock markets have been pandemic winners

Here in the UK, a little over a year since the coronavirus sell-off, the FTSE All-Share index that includes every company listed on the London Stock Exchange’s main market is still down 7% on its pre-pandemic peak. Wall Street, thanks to the influence of its big technology sector including the giants of Apple, Microsoft, Facebook, Amazon, Alphabet, Netflix and others, is 12% up on its pre-pandemic sell-off highs.

But Japan’s stock market, and equities in the Asia Pacific region more generally are up 28%. And a closer look reveals the equities sub-category that has proven to be the last year’s biggest winner is perhaps something of a surprise – smaller Chinese companies. Chinese small caps have returned a mightily impressive 73% over the past 12 months, according to financial markets data analysis company Refinitiv.

Chinese small-caps – a ship that has sailed or sector still at the beginning of a long growth journey?

Very few UK investors had the foresight, or luck, to expose themselves to China’s small-caps. A measly £1 million has flowed into the niche funds sector compared to £1 billion invested in Chinese large-caps.


Source: MSCI China Small Cap Index

China’s large-cap funds have certainly not been a poor investment with the sector returning 38% over 2021. But it’s the country’s smaller companies that have really caught fire. But have investors already missed out or is there more to come from the niche sector?

As a general rule, smaller companies tend to outperform during economic recoveries as it’s typically a time when investors are at their most optimistic. There is also the fact that smaller companies, while being riskier, have much more room to grow than alternatives or competitors that are already big. Ben Yearsley of consultancy Shore Financial Planning explains in The Times newspaper:

“Smaller companies have the ability to grow faster and occupy more interesting niches then their large counterparts. I’m a big fan of small cap investing and its benefits for the long term.”

There are some strong arguments why China’s small-caps will continue to be a sector investors may do well to have exposure to for years to come. The country has embarked upon a new economic shift away from fixed asset investments like infrastructure, real estate and manufacturing. The new focus is innovation, consumption and services and smaller companies are thriving in those areas.

Productivity, and value-enhancing technologies like automation, e-commerce, digital education and health care are sectors where the country’s smaller companies are thriving. They are also quickly growing sectors that are currently underrepresented in China’s large-cap focused benchmark indices and funds, representing an opportunity for smaller companies.

Their progress is far less restricted by already large companies limiting growth opportunities by leveraging an already dominant position to strangle or acquire competitive upstarts. And small caps are playing an increasingly important role in China’s economy.

china economy

Source: FundSelectorAsia

China’s small-caps sector has grown into the world’s largest small-cap market over the past decade. As a result, it also now offers investors a huge amount of choice and opportunities for diversifications. There are over 5000 public companies in China with a market capitalisation of less than $5 billion – the definition of a small-cap in the huge country.

foreign investors

Source: FundSelectorAsia

IT and healthcare are the two areas that have seen the greatest small-cap growth in China over the past 13 years. But a lack of interest from international investors means China’s small-caps are still relatively cheap when compared to international peers in ‘western’ developed stock markets.

The sector’s success and the fact international institutional investors are increasing their allocations to Chinese equities markets means a steady increase of international capital into the sector is forecast. That should small-cap valuations recalibrate at a higher level over the next few years, even against the backdrop of 2020’s strong gains.

small caps

Cheap Chinese small-caps even show superior earnings growth to their larger peers at home as well as small-caps from the USA and Europe. Other positive metrics include high return on equity and attractive earnings-per-share growth.

In combination, that all points to a narrowing of the valuations gap between China’s small and medium and large caps over coming years. As well as a narrowing of the gap between valuations of China small-caps and more expensive equivalent sectors in the USA and Europe.

Many investors, private as well as institutional, are already convinced greater exposure to China’s equity markets over the years ahead makes sense. Most have focused on larger companies. Adding exposure to the country’s small-caps could well maximise the potential for upside from any bets on Asia’s, and probable soon the world’s, largest economy.

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