Shenzhen Hong Kong Stock Connect: welcome aboard China Inc.

Francois Perrin and Karine Hirn, respectively portfolio manager and partner at East Capital comment the approvement of the Shenzhen-Hong Kong Stock Connect trading link by Chinese government and highlight further opportunities in the Chinese stock market.

The Chinese leadership just announced the long-awaited Shenzhen Hong Kong Stock Connect. Within 3 months, the Shenzhen Connect will offer retail and institutional investors full access to one of the most attractive pools of investment opportunities in the world. Welcome to the world of the Chinese private companies; welcome to the 21st century, made in China.

Financial reforms delivered
Running around the Peak in Hong Kong, you can now catch a glimpse of the City of Shenzhen on the horizon. It only happens on some (too) rare clear days, but Ping An’s skyscraper, located right next to the Shenzhen Stock Exchange, pokes the top of its 115 floors up between the hills of Kowloon.

A symbol of the structural reforms initiated in 1989 by Deng Xiaoping, Shenzhen has over the last 25 years been at the forefront of China’s transition toward a more sustainable business model, based on innovation and private entrepreneurship.

Established in 1990, a year after the Shanghai Stock Exchange, the Shenzhen Stock Exchange (SZSE) has played a significant role in financing the most innovative and dynamic part of “China Inc.”. SZSE today hosts more than 1,700 companies. With USD 3.4tr total market capitalisation and an average daily turnover of over USD 60bn, SZSE is the largest and most active domestic equity market in China, ahead of Shanghai.

With the launch of the Shenzhen Connect, the full set of major financial reforms announced three years ago by President Xi has been delivered: interest rate liberalisation, capital account opening, inclusion of the Chinese Yuan in the IMF’s Special Drawing Rights basket, and the opening of financial markets.

Shenzhen versus Shanghai: the tale of two Chinas

SZSE and its associated boards – the Main Board, Small and Medium Enterprises Board (SME) and Chinext Board (the equivalent of the US Nasdaq) – offer very distinctive and unique features related to size, liquidity, private ownership and new economy exposure.

The Shenzhen market has significantly more small-cap stocks than Shanghai, with an average market cap of about half of that of Shanghai listed shares. Due to the Mainland’s investment style, which favours small-cap and high-growth stocks, trading in the Shenzhen market has been very active.

The Shenzhen market is particularly liquid when compared with other regional and global markets. For instance, Do-Fluoride Chemicals, Tianqi Lithium Industries or Jiangxi Ganfeng Lithium are probably only familiar names for environmental protection specialists.

As typical Shenzhen mid-cap companies, they won’t remain unknown to international investors for long, as they are the largest lithium producers for the booming electric vehicle industry in China, and very liquid stocks. The average value traded daily on these names is higher than that of Tencent (China’s most prominent gaming and social messaging company), and two to three times more than Samsung or TSMC. Almost 75% of the most liquid names in an aggregated Asia ex-Japan + Shenzhen universe are from Shenzhen.

The Shanghai market is dominated by state-owned enterprises (SOE), while non- SOEs account for 75% of the total market in Shenzhen. Non-SOEs tend to be more efficient and profitable.

For instance, the 2016 return on common equity (ROE) for the Shenzhen SME Board Index is almost 1.5% points higher than the Shanghai Composite Index (13.2% versus 11.8%, source: Bloomberg, July 2016), and SZSE provides greater exposure to sectors that represent the “New China”, such as the IT, consumer discretionary, healthcare and environmental protection sectors.

IT is the largest sector on the Shenzhen market, accounting for 21% of the market cap. The consumer discretionary and healthcare sectors account for 17% and 9% respectively. These new economy sectors are at the heart of the transformation of the Chinese economy, and have in recent years consistently delivered relatively stronger earnings growth than other sectors. They are also less impacted by the economic slowdown.

ESG credentials of Shenzhen Stock Exchange listed names
SZSE issued as early as 2006 “Social Responsibility Instructions” for the listed companies, and it has been at the forefront on ESG disclosure ambitions on Chinese onshore markets. Tackling protection of shareholders and creditors, employees, suppliers, customers, the environment and social welfare, these instructions favour transparency and the issuance of appropriate sustainability reporting.

SZSE and the China Securities Regulatory Commission (CSRC) moved one notch further at the beginning of July 2016 in banning firms that have violated environmental protection laws within the past three years of floating new shares.

How does the Shenzhen Connect work?

Trading and settlement are similar to the Shanghai Hong Kong Stock Connect (Shanghai Connect), launched in November 2014. The Shenzhen Connect offers access to more than 500 Shenzhen-listed names for international investors via the “Northbound” channel and to circa 150 small and mid cap Hong Kong-listed names for mainland investors via the “Southbound”.

It is interesting to note that the entire MSCI China A-shares’ constituent list has now been included in the Northbound eligible list, and MSCI Inc. should appreciate this opening of the market when reviewing it for its decision to include A-shares in its indices.

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