Here's the Easy Way to Pick a China Stocks Winner

  • Large caps rise to highest level in four years versus market
  • Bocom says divergence will continue as deleveraging persists

A customer looks at an electronic stock board at a securities firm in Shanghai.

Photographer: Tomohiro Ohsumi/Bloomberg

In China’s struggling stock market, it’s easy to pick a winner. Back the state.

The SSE 50 Index comprising some of China’s largest companies has surged 6.4 percent in the past month, climbing to its highest level versus the broader Shanghai Composite Index in four years. Outside of the state giants, the rest of the market looks blighted: more companies on the Shanghai measure were at 52-week lows last week than at any time since 2013.

The outperformance is being driven by government policy: a regulatory campaign to curb leverage is driving up funding costs for smaller, privately-run firms, while also prompting an exodus by individual investors from equities. To avoid a deeper selloff, state-backed funds -- known locally as the national team -- are shoring up the market through purchases of large-cap shares, according to CIMB Securities Ltd. Last week’s sovereign rating cut by Moody’s Investors Service only added to the impetus.

"The national team is likely supporting the market again after Moody’s downgraded China in order to prevent panic selling," said Zhang Haidong, a Shanghai-based fund manager at Jinkuang Investment Management. "Blue chips such as banks are their favorite since the sector is cheap and has a relatively big weighting in index. Meanwhile, as individual investors have turned defensive in a bearish market, some of them have adjusted their strategy to sell small caps and follow the national team."

Insurers and lenders led gains in the past month on the SSE 50, with Ping An Insurance Group Co., New China Life Insurance Co. and China Merchants Bank Co. surging more than 18 percent. That’s helped the index rise to its highest level since December 2015. Compare that with the dismal performance of small caps, with the ChiNext gauge sinking to its lowest in more than two years.

Even without government support for the stock market, large-cap shares had already been benefiting in a relative sense from the regulatory campaign to cut risk in the financial sector. With the state’s backing, they have a better chance of maintaining access to funding at attractive rates than smaller private firms.

Regulatory Storm

"Under China’s deleveraging campaign, funding cost has raised more for small companies than for the big ones," said Hao Hong, chief strategist at Bocom International Holdings Co. "The decline of small caps is far from an end. The divergence will continue to widen until the regulatory storm stops."

The lead by large companies only widened early last month, when an international summit in Beijing attended by President Xi Jinping spurred intervention in equities, according to ICBC International Research.

The nation’s equity exchanges told brokerages to notify clients that regulatory scrutiny would increase through May 16 as China hosted the Belt and Road Forum for International Cooperation, according to people with direct knowledge of the matter. State-backed funds stood ready to buy shares if needed, they said.

"Investors have been panicking and escaping from small caps," said Qiu Zhicheng, strategist at ICBC International Research. "The national team’s recent support to the big caps, especially around the time of the Belt and Road Summit, has accelerated the transition."

The May 24 surprise downgrade by Moody’s added to the buy case for large state-owned enterprises. With the move casting doubt on China’s ability to prevent the buildup of debt and threatening to undermine already brittle investor sentiment, the government was quick to defend the nation’s equity and currency markets.

The large-cap index staged its biggest weekly rally in 15 months, jumping 4.6 percent. That compares with a 0.6 percent gain by the Shanghai Composite and a 2.3 percent drop by the ChiNext gauge of smaller companies. The yuan climbed the most since January offshore, jumping 0.7 percent against the dollar, as surging interbank rates in Hong Kong hobbled bearish bets and Chinese banks were said to be hoovering up the currency.

The SSE 50 dropped 0.8 percent at the close on Friday, with Ping An falling from a two-year high.

While valuations on the small-cap gauge have crumbled from their giddy peaks during the 2015 stock market bubble, they’re still elevated relative to large SOEs. The ChiNext trades at 37 times earnings, more than three times the level of the SSE 50. 

That’s still too expensive for Ben Bei, director of Hong Kong and China strategy at CIMB Securities, who says the outlook for the nation’s largest companies remains more positive than the rest of the market amid likely state intervention.

"Given there is limited downside for these stocks, retail investors will follow suit and turn to these defensive stocks as the direction of the market is uncertain," he said. "If the PBOC continues to tighten, small cap valuations would decline further."

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