Shuli Ren is a Bloomberg Gadfly columnist covering Asian markets. She previously wrote on markets for Barron's, following a career as an investment banker, and is a CFA charterholder.

China Inc. is finally starting to shine -- as long as you don't look too far below the surface. 

Companies on MSCI's China and Hong Kong indexes have beaten earnings estimates by the most among major emerging markets this year, underpinning rallies of 40 percent and 25 percent respectively.

Positive Surprise
Companies in China and Hong Kong have registered the largest earnings beats this season
Source: Bloomberg, Morgan Stanley
Note: Statistics are weighted by net income.

Return on equity, a key metric for investors, has also improved, from less than 12 percent last year to 12.6 percent currently. What changed? 

Rising Returns
After sinking for four years, China Inc.'s return on equity has started to tick up
Source: Bloomberg

Consolidation is an important recent development. China is keen to reduce overcapacity in basic industries. In coal, for instance, many small mines have been forced to shut and utilization rates have risen as a result. The four leading coal producers now control about 70 percent of shipments within China, up from 50 percent in 2015, HSBC Holdings Plc estimates.

Profit at China Shenhua Energy Co. more than doubled in the first half as coal prices soared. Shenhua's Hong Kong-traded shares have provided a 58 percent return to investors so far in 2017, aided by a bumper special dividend declared in March.

There are plenty of other examples. In the liquor industry, Wuliangye Yiban Co. and Kweichow Moutai Co. now control more than 60 percent of the high-end market, giving them oligopoly power over retail prices. Their shares have soared 61 percent and 48 percent.

Don't forget, however, that the MSCI gauges track the market's bigger fish. Of the 149 companies on its China index, the least bulky has a market capitalization in excess of $2 billion.

The picture is less pretty when we look at the small fry. 

Among the 800-odd Chinese companies listed in Hong Kong, there is a drastic divergence in earnings and year-to-date returns, data compiled by Gadfly show. Large-cap companies -- defined as those with a market cap of $10 billion or more -- have so far reported median growth of 18 percent in sales and 23 percent in earnings for the first half.  

By comparison, the median small-cap company increased sales by 12 percent and earnings by only 9.5 percent. That might appear a counter-intuitive result to some, given that it should be easier to grow faster from a small base.

Wear Large Caps
Blue chips are outperforming small-caps in earnings growth and stock returns
Source: Bloomberg
Note: Median values are used. Large-cap is defined as over $10 billion market value, mid-cap $2-10 billion, small-cap less than $2 billion.

As a result, large-caps are investors' darlings this year, while smaller stocks have languished.

Think Big
Small-caps have underperformed this year
Source: Bloomberg

When Beijing wants to cut overcapacity, only the biggest fish -- or dragon heads, as they are called by Chinese media -- benefit. Others die.

It's a strategy that's working well for China's largest and best-known companies, but at what cost? Perhaps, while enjoying this year's outsized returns, investors should also ask what it may be doing to the country's entrepreneurial spirit.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Shuli Ren in Hong Kong at

To contact the editor responsible for this story:
Matthew Brooker at