Southbound trade: diversification from renminbi exposure for mainland investors and massive valuation gap
The valuation gap is substantial; Shenzhen Composite Index trade at a forward P/E ratio of 24x versus Hang Seng Small Cap Index trading at a P/E ratio of 14.9x.
Since the beginning of the year, Hong Kong-listed names offering attractive yields have become an instrument of choice for mainland financial institutions through Shanghai Connect. In the context of abundant domestic liquidity, Renminbi depreciation pressure and tight control over cross-border fund flows via underground channels, the Shenzhen Connect is becoming another official channel for offshore investment, which will increase mainland activity on the Hong Kong market.
Small cap names will most likely experience sizeable inflows and an increase in volatility. For us, we see attractive opportunities in the environmental space, as the narrowing valuation gap with mainland peers will benefit high-quality names active in water treatment and infrastructure, wind and solar operators, and industrial waste management.
Northbound trade: access to the best opportunities of the new economy
For international investors, Shenzhen Connect will expand access to sectors within the new economy, leading to a more balanced China exposure. The valuation gap may restrain trading activity at the initial stage of the launch; besides international investors may need time to ramp up their knowledge and confidence on this still very under-researched universe. Nevertheless, Shenzhen will emerge as the go-to place to capture Chinese domestic champions on track to become global leaders.
In the cleantech space, Shenzhen offers, for example, some unique investment opportunities in the areas of electric vehicles, air pollution control technologies, energy efficiency, automation, and soil treatment.
If local retail investors will continue to dominate the flow, it is expected that overseas institutional investors will focus more on Shenzhen than Shanghai because this is China in the 21st Century.
Beyond the expected short-term rally benefitting both Shenzhen and Hong Kong, it is critical to realise that Shenzhen Connect is a stock-pickers’ game. We would therefore recommend international investors not to blindly focus on the “new economy”.
Investors should be selective and position themselves on structural trends shaping the future of China and its people, in order to mitigate the intrinsic volatility of these markets and the macroeconomic headlines. Shenzhen is where investors will find growth opportunities at reasonable prices and get access to superior returns.
Under that paradigm shift, environmental protection industries in China stand out. Trading at a P/E ratio of 14x for 22% earning growth in 2016, environmental protection industries offer perfect exposure to the financial opening of China and to the launch of Shenzhen Connect.