Imagine two countries. In one, the economy grows slowly and its stock market moves at a similar pace. The other country’s economy grows by leaps and bounds, but its stock market just seems to get worse and worse.
I have just described the current state of affairs in the U.S. and mainland China.
In the last five calendar years, U.S. Gross Domestic Product has grown approximately 12 percent on a cumulative basis, to over $15 trillion. Meanwhile, the U.S. stock market (measured by the S&P 500 Index, including dividends) has cumulatively grown by slightly over 8 percent. There have been ups and downs along the way, but both measures remain relatively flat. China’s GDP, on the other hand, has been off the charts. Over the last five years it has grown 136 percent, to over $8 trillion. But despite this booming growth, the Shanghai Stock Exchange Composite Index, the main stock market in mainland China, has declined over 50 percent.
That is not a typo. A typical investor might expect China’s markets to be lapping those in the U.S. by a wide margin, given the difference in the countries’ GDP growth. Nor is the Shanghai Stock Exchange some fly-by-night market; by market capitalization it is the sixth largest market in the world. Why is such a big stock market in a country experiencing rapid growth such a mess?
There is not a simple answer to this question. There are many factors contributing to the Shanghai index’s underperformance.
First of all, there was a bubble in the Shanghai market during 2006 and 2007. This wasn’t just any bubble; the market more than quadrupled. From its peak in late 2007, the Shanghai market had dropped over 60 percent by the end of 2012. While the bubble had a dramatic impact on the index’s 5-year return, if we go back even farther, the numbers are still surprisingly weak. Over the last 10 years, the U.S. GDP has grown 47 percent on a cumulative basis, while the stock market has nearly doubled. At the same time, China’s GDP grew over 467 percent, while the index only grew 67 percent. Based on these numbers, problems with the Chinese stock market go deeper than the recent bubble.
An important consideration that may account for some of the discrepancy is that the Shanghai stock market is largely closed to foreign investors. The exchange lists “A-shares” and “B-shares.” A-shares make up over 99 percent of the market and, unlike B-shares, are generally available only to Chinese nationals.
Partly as a result, mom and pop investors make up approximately 80 percent of those investing in the market in Shanghai, unlike American markets, where large investors such as pensions, hedge funds and financial institutions play a major role. Many investors, both in China and abroad, gave up on investing in Chinese stocks after the bubble burst and haven’t returned. Additionally, due to China’s higher interest rates and lack of a social safety net like Social Security, many Chinese investors choose to focus on more conservative bank-sold products instead.
Because of this reluctance from Chinese investors, and perhaps also as a result of the restrictions on foreign investors, Shanghai’s supply of stocks has outpaced demand. Unlike the U.S., where initial public offerings have dropped off steadily in recent years, Shanghai has continued to see many new companies enter its market. The number of U.S.-listed companies peaked at 9,000 in 1997; it has since dropped to below 5,000. Over 2,000 listed securities are already traded on the Shanghai exchange, and recent data released by China’s securities regulation entity indicated there are over 800 IPO deals in the pipeline for A-shares.
Differences in corporate culture may also make it hard for the Shanghai exchange to lure or retain investors. For example, Chinese firms appear less willing to pay dividends, which might make up for an otherwise weak return on investment. Sixty percent of Shanghai-listed companies currently pay no dividends at all. The exchange itself recently required that companies either pay out 30 percent of their profits as shareholder dividends or explain why they cannot do so in their annual reports. In the U.S., the average dividend payout ratio is approximately 30 percent, and companies also return substantial amounts of cash to investors using share repurchases.
Besides the Shanghai market’s low returns, investors may also be wary because of poor disclosure. Not only are documentation standards lower than in the U.S. and much of the West, Chinese accounting standards are more lenient too, making it easier for the Chinese firms listed in the exchange to misrepresent their financial situations. This may undermine investors’ confidence, especially for foreign investors.
Ultimately, comparing the markets in the U.S. and Shanghai is not a fair, apples-to-apples comparison. After all, the U.S. economy is much more solidly grounded in capitalist principles. Its stock exchange is, by and large, used as a means to allocate capital and to reward growing companies and their shareholders. The Shanghai exchange seems to be used largely as a means for the state to recapitalize or restructure its own companies. The efficiency of its market is a secondary concern.
It wouldn’t be appropriate to leave the Hong Kong Stock Exchange out of this discussion. More evidence of the problems in Shanghai’s exchange can be seen by comparing its performance to the Hong Kong market. After all, both markets offer exposure to stocks in the same region, but stocks on the Hong Kong exchange offer better disclosure and are available to foreign investors. Over the past 5 years, the MSCI Hong Kong Index appreciated 4 percent (compared to the over 50 percent drop in Shanghai), and its 10-year return is 257 percent.
As an investment adviser, Palisades Hudson Asset Management allocates a portion of each client’s portfolio to Chinese stocks. However, virtually all of this exposure is purchased through the Hong Kong exchange. Two of the funds Palisades Hudson uses own shares in China Vanke, a major real estate developer whose stock is traded in mainland China as a B-share. However, the company announced in January 2013 that its stock would migrate to the Hong Kong exchange. The company’s stock jumped 10 percent immediately after the announcement.
Some analysts believe the Shanghai market is currently undervalued, and continue to wait for the cyclical rebound they believe is inevitable. A more likely outcome is that, over time, the Shanghai exchange will make adjustments to become more similar to Hong Kong and other major exchanges. There are many roadblocks preventing the Shanghai market from attracting investors looking to generate wealth. Only after removing those roadblocks and letting capital flow more freely will this huge market become one worth entering.
