Recent regulatory changes in China have attracted a lot of attention from investors. Chinese equities have significantly underperformed and now look extremely cheap on an absolute and relative basis.
Last month, we addressed the change in the regulatory environment. In this note, we analyse the extent to which Chinese equities have underperformed, how cheap Chinese equities are (especially compared to US equities), and how the portfolio is positioned vis-à-vis these issues.
We focus on Hong Kong listed stocks as most (greater than 80%) of the Fund’s Chinese equity gross exposure and nearly all (greater than 90%) of the Fund’s Chinese equity long exposure is in Hong Kong listed stocks. All calculations are performed using close of trade data on 29 August.
Chinese Equity Underperformance
Since the fund was launched in June 2020, the Hang Seng Index has considerably underperformed major global indices, particularly the S&P 500 and Nasdaq indices. Chart 1 illustrates the performance of the indices (basing each index to 100 as at 1 June 2020).
Chart 1: Index Relative Performance
Source: Bloomberg
This analysis is distorted by the large cap technology stocks listed in the United States and Hong Kong. These stocks have large index weights: for example, the combined weight of Apple, Microsoft, Amazon, Facebook and Alphabet in the S&P 500 and Nasdaq indices is more than 22% and 40% respectively; and the combined weight of Alibaba, Tencent and Meituan in the Hang Seng Index is more than 20%. The extremely strong relative outperformance of US listed technology stocks has obviously contributed to the Hang Seng Index’s underperformance.
A broader and more meaningful performance comparison can be made by looking at median returns across a broad universe of stocks in each market. Chart 2 shows the median return for US and Hong Kong stocks covered by 2 more analysts over different time periods ranging from one month to one year. The relative performance of Hong Kong listed stocks has been particularly poor over the last year.
Chart 2: Relative Market Performance (Median Returns)
Source: Bloomberg, OQFM
Chinese Equity Valuations
The following analysis uses one year forward earnings yield and one year forward dividend yield as value proxies. The value factors used in our stock selection process are more sophisticated but less relatable and more opaque. To minimize the distortionary impact of outliers, we use median as the measure of central tendency. The stock universe comprises all stocks covered by two or more analysts in Hong Kong and the United States.
The earnings yield in the United States is less than half the earnings yield in Hong Kong, and the dividend yield is less than one third (Chart 3)
Chart 3: Value Difference based on One Year Forward Earnings Yield and Dividend Yield
Source: Bloomberg, OQFM
We then look at the percentage of stocks within different earnings yield bands. It is interesting to note the relatively large number of United States stocks which are extremely expensive and relatively large number of United States which are extremely cheap (Chart 4).
Chart 4: Value Difference based on One Year Forward Earnings Yield
Source: Bloomberg, OQFM
Portfolio Positioning
The portfolio is net long Chinese equities listed in Hong Kong and, via short S&P500 and Nasdaq futures contracts, net short US equities. As at 29 August 2021, on a beta adjusted basis, the net exposure to China/HK equities is +10.3% (using a daily 6-month beta with the Hang Seng Index as the market proxy). The net exposure to US equities via short futures positions is -16.2% (-9.0% S&P 500 and -7.2% Nasdaq).
Within our portfolio of Hong Kong listed stocks, we have an extremely strong value bias. Chart 5 shows the value scores for the long and short portfolio based on one year forward earnings yield and one year forward dividend yield (weighting each stock by its holding percentage in the long and short portfolios).
Chart 5: HK Long & Short Portfolio One Year Forward Earnings Yield and Dividend Yield
Source: Bloomberg, OQFM
The Fund’s long Hong Kong portfolio also comprises numerous holdings which have net cash on their balance sheets. Excluding Financials:
Two large long positions representing more than 5% of the Hong Kong long portfolio are trading below net cash backing (2386 HK) or very close to net cash asset backing (552 HK); both companies have reasonably strong growth profiles (especially 552 HK) and are generating strong earnings and cashflows
More than 20% of the Hong Kong long portfolio has net cash greater than one quarter of market capitalisation
Almost 35% of the Hong Kong long portfolio has net cash.
Justification
The net long position in China (largely via HK listed equities) and the net short position in the United States (via short index futures positions) has materially detracted from the Fund’s performance. This net country positioning is also close to the outer bound of what we tolerate from a risk perspective.
Given this, we need a strong justification to maintain this positioning. We currently believe this risk tilt is appropriate for the following reasons:
(i) Value differential
As discussed, there are numerous Hong Kong listed stocks which are extremely cheap. Our long Hong Kong portfolio also contains numerous stocks with extremely strong balance sheets which have strong downside protection. In contrast US stocks, especially the key index stocks in the futures contracts in which we have a short position, are relatively expensive.
(ii) Appropriate risk tilts to hit our volatility target
As discussed in our recent research note on volatility targeting, risk tilts are an appropriate way to generate return volatility. The alternative – being highly risk constrained and using high leverage – is costly and a potential tail risk due to forced unwinds, as evidenced during the Great Quant Unwind. Currently we believe the risks associated with our net country positioning are manageable – indeed the Fund’s alpha generation has been strong during the period when Chinese equities have significantly underperformed. We also believe our long China/HK portfolio provides good medium-term upside based on the quant factor data and additional non-systematic analysis performed by the portfolio management team.
(iii) Currency hedge
A risk associated with net country tilts is adverse currency movements. We hedge our currency exposures, but currency moves impact relative share price performance across countries and hence are relevant. A depreciating Yen, for example, is likely to boost Japanese equities (in local currency, all other things being equal). Given the Hong Kong dollar is pegged to the United States dollar, a long equities position in Hong Kong and a short US futures position is currency hedged.
(iv) Cost of shorting
Based on our backtests and investment experience, the cost of getting short exposure can easily erode alpha. This is particularly problematic in Asia given the relatively high cost of borrow in markets other than Japan and Australia. The cost of selling S&P500 and Nasdaq futures positions is minimal. There is no material basis risk and the contracts are extremely liquid with a quarterly roll.
(v) Short portfolio breadth We discussed the importance of this issue in July. Excess liquidity driven by monetary and fiscal stimulus globally has resulted in too much money chasing too few investment opportunities. This is particularly problematic with short positions given the potential for unlimited losses. The best defense against this issue is breadth. Index futures contracts generally provide large breadth, but this varies by market. In Korea, for example, the index futures contract is dominated by Samsung Electronics and in Taiwan, the index futures contract is dominated by TSMC. This is not an issue in the United States with both the S&P 500 and Nasdaq futures contracts providing high breadth.
Dealing with Chinese Risks
Notwithstanding what we believe is a robust justification, we are actively monitoring the Fund’s net long Chinese exposure. This includes:
(i) Closely monitoring Chinese regulatory risks
The Fund is currently slightly net short internet stocks and education stocks which have been impacted by recently regulatory reforms in China. We do have a net long exposure to property stocks (approximately 1.7% of AUM) which may be impacted by policies that seek to address housing affordability. We are closely monitoring this situation.
(ii) Focusing on stocks with sustainable dividends
We believe that several long Chinese positions offer strong downside protection given their high and sustainable dividend yields. These dividend yields are underpinned by strong cashflows and balance sheets. Some of these stocks have been impacted by US government sanctions – the listed telecommunication stocks being prime examples – but any residual selling pressure will only persist up until 11 November 2021, by which time US investors are required to have sold their shareholdings.
(iii) Running risk screens for Chinese stocks This is a core component of our investment process. As fewer stocks come through our short alpha screens than our long alpha screens (given we have fewer short alpha screens and we can only short stocks that have borrow availability), we supplement short alpha positions with short risk screen positions. These risk screens are based on a linear multi-factor alpha. We are running a risk screen across Chinese equities on a daily basis.
Summary
Chinese stocks have materially underperformed, particularly relative to United States equities. This has negatively impacted the Fund’s performance.
The Fund’s long China portfolio is extremely cheap based on valuation factors. Many positions also have large net cash holdings relative to their market capitalisations and high sustainable dividend yields. We believe this offers good downside protection.
We currently believe our net country positioning is appropriate. Nevertheless, we are actively monitoring the situation and if anything happens which undermines our investment thesis, we will reposition the portfolio accordingly.
If relative share price performance closes the value differential, we will also gradually unwind this risk tilt. We believe this is the more likely scenario. It is also a favourable outcome in that it would result in a strong positive performance contribution.
Comments