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Traditionally, global investors have accessed the Chinese market in two ways: through investments in its offshore-listed companies – often its internet giants – or in multinationals selling to Chinese customers.
But the picture is changing. China’s domestic A-share market now surpasses both the New York Stock Exchange and the NASDAQ in number of listed companies.
In early 2023, as pandemic-era restrictions eased, I took the opportunity to spend a week with Baillie Gifford’s Shanghai-based research team. Despite having endured a volatile period for Chinese equities as well as a challenging lockdown, I was struck by the team’s undimmed enthusiasm for the opportunities in the domestic A-share market.
Reflecting a changing China
China’s economic centre of gravity is shifting. Policymakers now emphasise quality as opposed to quantity of growth. Rather than output alone, the focus is on innovation and productivity. Economic slowdown may lead to deceleration in consumption and production, but might also foster adaptation and innovation, advantaging companies aligned with China’s broader development goals.
For our Shanghai team, the excitement of the A-share market comes from how it reflects these structural changes. A decade ago, sectors such as real estate, mining, and financial services formed the bulk of the A-share market. Now, companies from fast-growing areas, including IT infrastructure, biotechnology, and semiconductors, are replacing them. Many of the best companies in these fields can only be found in the A-share market.
A-share market vs offshore market: sector breakdown
While low correlation with international markets heightens A-shares’ diversification benefits, asset allocators need to be aware of China-specific risks. Domestic regulation and geopolitical tensions can pose substantial challenges to individual investment cases. However, Baillie Gifford’s three decades of investing in Chinese companies have shown that generalisations about China can blind investors to real opportunities.
It is vital to focus on areas where public policy and companies’ profit motive are aligned.
It helps that, despite the perceived opacity in its regulatory framework, China tends to make its long-term policy objectives extremely clear. The government’s motives are rooted in the country’s challenges. These include:
- Self-sufficiency: Two of China’s largest import bills are oil and semiconductors. This makes energy security and technological self-sufficiency crucial in an era of increasingly complex and competitive geopolitics. The result is a strong government commitment to renewable energy and the domestic semiconductor industry.
- Healthcare and productivity: China’s 1.4 billion population is ageing, motivating policymakers to invest in healthcare and to push for productivity gains by digitalising and automating traditional sectors.
- Climbing the value chain: China has already lost lower-end manufacturing jobs to neighbours such as Vietnam, hence its desire to move up the value chain via innovation in advanced manufacturing, digital commerce, and IT infrastructure.
A broad-brush dismissal of China based on geopolitical concerns risks missing the many exciting opportunities in domestic markets. Long-term investors should look beyond nationalist rhetoric and focus on the actual impact on sectors and companies. This requires case-by-case analysis.
While Baillie Gifford remains humble about its inability to predict regulatory change or geopolitical tensions, we believe it’s rewarding to focus on selected companies where higher conviction is possible.
With this in mind, I asked each of our Shanghai-based researchers to tell us where they found the most exciting opportunities. Their answers reveal the abundance of A-share riches to choose from.
Next generation economy
It’s the gradual, generational shift in consumer preference, rather than the amount of consumption that draws our interest.
– Linda Lin, joined Baillie Gifford in 2014
Arriving at Pudong airport for the first time since the pandemic, my first surprise came from the vending machine.
Instead of Coke, it offered a vast range of fizzy drinks from a domestic brand, Genki Forest. Another surprise was when Linda showed me the ‘robo shop’ in the canteen area of our office building, selling trending toys from designer figurine company Pop Mart. These homegrown brands have seen a remarkable rise in popularity among China’s young ‘Gen Z’ shoppers, including a few in our Shanghai team.
Born after 1995, Gen Z consumers grew up with a smartphone to hand and are more confident in their Chinese identity. Where their parents aspired to a Sony Walkman, today’s young embrace domestic brands – from drinks to skincare to sportswear.
But Gen Z is anything but homogenous. Companies that can cater to their tastes and engage them in a culturally relevant way stand the best chance of success.
Here, domestic brands have an edge. In cosmetics, for instance, homegrown companies’ share has grown consistently faster than the overall market volume in recent years. Makeup and skincare company Proya, one of Linda’s top A-share picks, is well-positioned.
There are 270 million Gen Z consumers in China, destined to become its main consumer cohort. For brands planning on becoming big winners, their preferences matter. Investing only in international companies selling to China won’t capture these opportunities.
IT infrastructure
Localisation and digitalisation are two driving forces that put China’s IT sector in the spotlight.
– Tony Wang, joined Baillie Gifford in 2020
Baillie Gifford has made many successful investments in the IT sector in the past. Long-term ownership in Amazon (cloud services), Salesforce (software-as-a-service), as well as NVIDIA and TSMC (semiconductors), have rewarded clients handsomely.
“The industry knowledge of global colleagues helps me research similar opportunities in China,” Tony told me.
China’s software spending as a percentage of GDP is less than a third of that of the US. The country consumes around 40 per cent of all chips made globally, while supplying only 12 per cent of its own needs.
International tensions have led Chinese customers to prefer local IT suppliers for both software and hardware. Domestic chip designers such as SG Micro are benefiting from this localisation trend.
Meanwhile, China’s economic transition requires the government to incentivise software spending. Its enterprise resource planning (ERP) market is expected to grow faster than the global market, albeit from a relatively small base.
One of the potential beneficiaries Tony referred to is Yonyou, a leading ERP provider, listed as an A-share. Founded in 1988, Yonyou has decades of knowledge acquired from working with China’s largest corporate clients. It could become the go-to provider for the many enterprises that prefer local vendors.
Innovative healthcare
When researching an investment idea, I like to start with one question: what problem is this business trying to solve, and how significant is it?
– Rio Tu, joined Baillie Gifford in 2014
China has more than 140 million diabetes sufferers, twice as many as there are people in the entire UK. Fewer than a quarter of Chinese patients have access to adequate blood glucose control methods, significantly lower than the global average.
Rio’s interest came not only from the significant investment opportunity that solving this problem represents, but also from a wish to help his mother, who has diabetes.
On joining Baillie Gifford a decade ago, Rio came across a research paper from a colleague in one of our global teams, discussing a new method of continuous glucose monitoring (CGM), pioneered by US firm Dexcom. This method greatly improves long-term patient outcomes, compared with the traditional finger-prick, which only gives a momentary snapshot of blood sugar levels. This led to Rio’s discovery of Sinocare.
As with many other A-share companies, there is very little sell-side research coverage of Sinocare. Why does it look like a winner? Rio believes that to succeed a healthcare company must be able to improve patient outcomes and lower the cost of care. By automatically tracking blood sugar levels throughout the day, Sinocare’s CGM helps patients make more informed decisions about balancing their food, physical activity and medication, minimising the risk of irreversible damage from excessively high or low glucose levels.
“China has an ageing population and there is an urgent quest to invest in healthcare. True innovators will benefit from this ‘great leap forward’,” said Rio.
Industrial upgrading
China’s labour market faces multiple challenges. The working-age population pool is shrinking, labour costs are rising, and the younger generation is less willing to do repetitive factory work. All of these factors drive the need for more automation.
– Louise Lin, joined Baillie Gifford in 2014
China is the largest market in the world for industrial robotics. More than half of the global new industrial robot installations in 2021 were in China. Yet the country’s robot ‘density’ is still well below the global leaders. It has 322 robots installed per 10,000 workers, less than a third of the amount in South Korea. The demand for ‘machine substitution’ in China’s manufacturing industry is strong.
Louise is the Shanghai team’s expert in this sector. Before relocating here, she was based in Edinburgh with Baillie Gifford’s European and Japanese investment teams. Both have long invested in leading automation companies.
Louise came across Inovance, an A-share company that focuses on various motion control products when researching the competitive landscape of its Japanese competitor Yaskawa. The team first wrote a report on Inovance in 2015, years before A-shares were included in MSCI indices.
Since then, Inovance has delivered impressive growth. Its top line has grown by an average of more than 40 per cent per annum for the past 10 years.
When asked how a Chinese company such as Inovance thrives amid fierce competition with some of the most advanced industrial global peers, Louise highlighted three qualities:
- a flexible product strategy and willingness to customise
- capacity to operate at scale, largely thanks to China’s vast pool of engineers
- strength in research and development and sales strategy, led by an impressive ex-Huawei management team
Inovance has gradually moved from the lower end of the market to take market share from European and Japanese incumbents.
As China grows its higher-end manufacturing capability in sectors such as electric vehicles, renewable energy, and large-scale chemical production, domestic automation companies have an opportunity to progress alongside their customers to become world leaders.
“We think Inovance has the potential to become the Siemens of China over the next decade,” said Louise.
Energy transition
Experts estimate that the green transition in China could achieve more economic output than platform businesses unlocked in the past decade.
– Freddy Zhu, joined Baillie Gifford in 2020
Freddy grew up in a coastal city in southeast China where blue sky and a fresh breeze were taken for granted. He first witnessed air pollution in Beijing when at university there in the early 2010s.
“Most people didn’t know much about measuring pollution levels back then,” said Freddy. “But they could easily be ten times higher in Beijing than WHO guidance recommends.” Freddy’s interest in climate change reflects the increasing awareness among Gen-Zs in China. He joined our team after graduating in environmental science and working as an energy sector analyst. One of his first research projects was LONGi green technology, a solar module producer.
“LONGi played a crucial role in achieving ‘grid parity’,” Freddy asserts. Founded in 2000, the company made its name as a pioneer of monocrystalline silicon technology. Disruptive at the time, it proved more efficient than other technologies. It now dominates the global solar panel market, thanks to LONGi’s manufacturing advantages and continuous cost reduction. Today LONGi is the world’s largest producer of solar panel wafers and modules. Its primary appeal is the immense market opportunity, with the near certainty of multi-decade demand growth.
Combining that with LONGi’s scale advantage as an early mover, which allows it to outspend peers on research and development, it’s hard to imagine it not benefiting from the global move towards decarbonisation.
“It’s not only in solar,” said Freddy. “The uplift of ecosystems in, for example, China’s electric vehicle and wind industry, also gives us interesting investment opportunities along the supply chain: from batteries to high voltage subsea cables, to green hydrogen.”
Summing up: rich pickings
Within a little over two decades, the A-share market has become the second largest in the world by market capitalisation, yet it comprises less than 1 per cent of the MSCI All Country World Index. It is now the major initial public offering channel for Chinese companies. The number of listed A-shares has quadrupled to more than 5,000, and barriers to foreign access have never been lower. Headlines in recent years could draw attention from these developments, the direction of which has been consistent for decades.
Under-represented and under-owned, the A-share market is a rich hunting ground for long-term, active stock pickers in a young, inefficient market. The research of our Shanghai team underlines how A-shares offer some of the most exciting transformations underway in the world’s second-largest economy.
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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions. This communication was produced and approved in September 2023 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
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