Small Caps: China’s Engine of Domestic Growth and Innovation

China is facing a range of challenges due to a combination of external geopolitical forces and internal forces of its own making. The world’s second-biggest economy accounts for about one-third of global growth, more than the combined share of the U.S., Europe, and Japan.¹

But the country’s strict zero-COVID policy has put much of its economy on standstill most recently. Lockdowns have led to first and second quarter growth stalling, and we have already seen downward revisions to earnings. In the MSCI China Index, growth forecasts for this year have been reduced to around 5% at the end of June (and in some cases more) from a previous estimate of around 15% given the challenges faced so far this year.²

We believe growth will return when zero-COVID policy ends

Given that most of the severe COVID lockdowns happened in the earlier part of March, we are bracing for a rough second quarter.

But with the government’s strict COVID policy likely easing in the second half of the year and high commodity prices coming down a bit from their peak, we are optimistic that earnings will improve in the latter half of 2022.

We are cautious, however, because easing of zero-COVID will largely depend on China adopting a better vaccination strategy. Only 20% of its 30 million elderly population over the age of 80 had received a booster jab.³ For these reasons, we think reopening of the economy is likely to be a gradual process.

While growth in China is currently subdued, we believe it is poised to recover given the paucity of economic good news in the rest of the world with rising inflation and interest rates. China continues to be on a path of easing. Therefore, we believe the prospects of growth in China rerating over time are good.

Economic recovery needs to happen in conjunction with commodity prices falling slightly along with some kind of stimulus support. While many uncertainties remain, our view is the Chinese government has a healthy balance sheet, and still has monetary and fiscal levers it can pull to foster stable growth for the rest of this year.

Given that China’s economy was already quite healthy before the Omicron strain arrived a few months ago, we are broadly confident that COVID restrictions easing, coupled with potential post-COVID stimulus could lead to an improvement in sentiment and a boost to the economy.

Meanwhile, geopolitical headwinds such as global trade supply issues and Russia’s war with Ukraine continue to cause challenges.

Potentially unstoppable trends

Despite the uncertainties, there are unstoppable trends in China that are associated with income growth, technology, manufacturing, and energy self-sufficiency, as well as market share opportunities and gains in complex supply chains that have historically been dominated by foreign players.

Many of these trends, especially digitisation, automation, and self-sufficiency in technology and energy, are secular and poised to become potentially larger parts of China's economic activity over time. Our view remains that innovation will continue to accelerate in many areas of the economy, particularly in the IT, healthcare, automation, and renewable sectors in China. Investors could capture these potential growth opportunities by having exposure to the companies that are well positioned to participate in the country’s new economy and are driving China’s jobs, innovation and wealth.

Almost 88% of urban employment is now in small, privately owned, entrepreneurial companies.⁴ That is why we believe exposure to small caps enables investors to access the faster growing parts of the Chinese markets.

The country’s small-cap equity universe has expanded exponentially over the past decade to become one of the most sizeable, small company universes globally. China has over 5,000 local companies with a market cap of under US$5 billion.⁵ In our view, it also offers ample liquidity since around 80% of this universe trades on the domestic A-Shares market, which tends to be much more liquid than its Hong Kong peer.

The small cap universe has good representation of companies in growth-centric, new economy segments of the Chinese markets. We find that smaller companies thrive best in productivity- and value-enhancing industries such as automation, health care, e-commerce and education—areas which are under-represented in large-cap-oriented benchmarks and portfolios.

For example, in IT and healthcare, the small cap universe offers much higher exposure compared to the MSCI China Index, and there is also minimal overlap from a sector perspective, thus making these two categories of Chinese equities complementary to each other in our view.⁶

Find the best companies through an active approach

While China’s universe for small companies is wide, competition is high and there is minimal research coverage. Only the best-run, most innovative companies are likely to thrive and succeed. Therefore, we believe an active investment approach that conducts proprietary, fundamental research can help provide dedicated exposure to China’s most promising small companies.

We believe China’s small caps can complement a large-cap allocation to China’s equities. Indeed, many of our clients have used our China Small Companies Fund to differentiate and augment their China exposure whether they have a core China exposure or through a global or emerging markets exposure.

Furthermore, the domestic focus of small companies can potentially provide an element of protection against trade tensions and other geopolitical macro risks.

Positioning for when consumption rebounds

Looking forward, we are keeping a watchful eye on signs of improvement in consumption which would naturally benefit our portfolio. Some relief on China’s zero-COVID policy is expected to unleash more consumption activity, which is an important part of our portfolio given that close to 80% of the revenue stream derives from the domestic economy. Many of our investee companies are dependent on the wellbeing of the domestic economy and are heavily exposed to the impact of lockdowns.

At a time when earnings growth for small companies looks attractive and valuations are low, we believe this is an opportune period to get exposure to domestic China growth through a dedicated and actively managed investment strategy.

Winnie Chwang
Portfolio Manager
Matthews Asia

¹ International Monetary Fund, October 15, 2021