Xi’s Dream for a High-Tech China Is Becoming a Reality in Stocks

  • Weighting of technology stocks in MSCI China Index may double
  • `Better and fairer' representation of China, Aberdeen says

A China dominated by high-value technology companies is about to become a reality.

That’s true for the stock market at least, even if a transformation of the world’s second-biggest economy is still years away. Technology firms’ weighting in MSCI Inc.’s benchmark Chinese equity gauge will almost double to 26 percent by May, after a Nov. 12 review when overseas-listed firms from Alibaba Group Holding Ltd. to Baidu Inc. become eligible for inclusion, according to Goldman Sachs Group Inc. The change will affect investors with at least $400 billion of Chinese stock holdings and give the country a higher concentration of software companies than any other MSCI index worldwide.

The stock gauge’s evolution is a sped-up version of what President Xi Jinping’s government is trying to do for China’s economy: boost the role of privately-owned technology and service businesses while downsizing state-run industrial and financial giants. Investors have already made clear which group they prefer, with U.S.-listed Chinese technology stocks valued at levels almost four times higher than the MSCI China gauge.

“It’s a better and fairer representation of the China universe, which you don’t really see and didn’t really get in the past,” said Frank Tian, a Hong Kong-based investment manager at Aberdeen Asset Management Plc, which oversees $483 billion. “It’s certainly a step in the right direction.”

Financial Weighting

The weighting of financial companies in the MSCI China gauge will fall to 34 percent from 41 percent, with energy, industrials and utilities also declining, Goldman Sachs said in a Oct. 23 report. The changes may trigger $78 billion of net buying, the New York-based bank estimated. About $1.6 trillion tracks the MSCI Emerging Market Index, and China makes up about 25 percent of those positions, according to Chia Chin-ping, a managing director at the index compiler.

MSCI said in January that companies listed outside their home market should be included in national benchmark equity gauges. The additions are being phased in as part of the index compiler’s six-monthly reviews in November and in May. As many as 14 companies might be added to the MSCI China index, according to a simulation of the change, which also affects companies from Hong Kong, the Netherlands and Israel.

While China’s government doesn’t publish a breakdown of the technology sector’s contribution to gross domestic product, official data show the growing importance of service industries, which make up more than half the economy and expanded at a 8.4 percent pace in the first nine months of 2015. That compares with 6 percent growth in the industrial and construction sectors.

Index Drivers

The new MSCI China measure will be skewed toward companies that are shielded from the nation’s slowing economy, according to Adrian Mowat, the chief Asian and emerging-market equity strategist at JPMorgan Chase & Co.

“We’re worried about certain parts of the Chinese economy like steel and cement,” Mowat said. “But for the stock market, it’s not an issue because they’re a tiny percentage of the benchmark. What matters is what’s happening with e-commerce, online gaming, etc. That’s the driver of the index.”

Earnings at financial companies in the CSI 300 Index are projected to climb 16 percent in the next 12 months, compared with 28 percent for technology shares, according to analyst estimates compiled by Bloomberg. Agricultural Bank of China Ltd., the first of the nation’s big lenders to report third-quarter earnings, said profit increased just 1 percent from a year earlier. Alibaba’s net income, excluding one-time items, climbed about 36 percent over the same period as sales topped analysts’ estimates. Baidu’s third-quarter revenue jumped 36 percent.

Losing Bets

For all the optimism toward Chinese technology companies, Alibaba and Baidu, the two biggest projected additions to the MSCI gauge, have been losing bets in 2015 on concern that slower economic growth will hurt sales. Alibaba has also been dragged down by government scrutiny of counterfeits in its online marketplace, with the American depositary receipts slumping 21 percent this year. Chinese tech shares in the U.S., which trade at a weighted average of 37 times reported earnings, are both more expensive and more volatile than the MSCI China gauge.

“Those are growth stocks, so definitely by nature the high growth is high volatility,” said Paul Chan, the Hong Kong-based chief investment officer for Asia excluding Japan at Invesco Ltd., which oversees $776 billion globally. “But hopefully they will increase return.”

Market Opening

Most of the other potential new entrants have done better than Alibaba and Baidu, with JD.Com Inc. jumping 19 percent this year and NetEase Inc. surging 43 percent. A Bloomberg gauge of U.S.-listed Chinese companies is up 9.1 percent in 2015, compared with a 5.7 percent drop in the MSCI China index.

The overhaul still leaves mainland-listed equities out in the cold, with MSCI deciding in June to hold off on adding them to indexes because of their inaccessibility to foreign investors. It also means the MSCI China measure will be more technology-heavy than mainland gauges: the industry makes up just 7.3 percent of the large-cap CSI 300 Index.

For JPMorgan Asset Management’s Richard Titherington, next month’s changes are an intermediate step as China opens up its capital markets.

“Chinese equities are going to become an ever increasing part of the benchmark indexes,” said Titherington, the chief investment officer for emerging markets and Asia Pacific equities at JPMorgan Asset. “The big ADR listings, particularly the well-known Internet companies, are obviously an important part of the Chinese investment theme and therefore should be represented in benchmarks.”

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