Why Chinese SOEs? Why Now? (Part One)

15 of the top 20 state-owned stocks outperform Hang Seng YTD

Mar 26, 2023

Our CIO Charlie Chen and I met with institutional investors in Hong Kong this week. Charlie is a seasoned China fund manager, with over 26 years of experience in Chinese equities. He founded MegaTrust Investments in 2007 following a successful career as a best performing QFII portfolio manager in 2004-2007.

The investor response for our trip wasn’t great, as you can imagine the lack of interest in China currently. Several HK-based global investors we know have migrated to elsewhere: Singapore, Tokyo, Dubai or their home countries. Some told us they no longer focus on China, and are not coming back soon.

Despite my short-term positive view on the Hong Kong stock market, the sustainability of any rally is subject to question, given the strategic retreat by global investors from China markets.

As investors, we face not only the foreign outflows and increasing market volatility, but also a significant bifurcation (dispersion) of Hong Kong stocks. Stock-picking matters!

For example, the Hang Seng Tech Index (e.g. private firms like Tencent and Alibaba) is up 2.3% YTD (as of March 24), while state-owned companies like China Telecom (0728.HK) is up 32.2%, China Communications Services (0552.HK) +31.9%, CRRC (1766.HK) +30.5%, and China Communications Construction (1800.HK) +25%… Just to name few.

The performance disparity between private and state-owned enterprises (SOEs) in Hong Kong is more obvious on a risk-adjusted basis. For example, both Tencent (0700.HK) and China Mobile (0491.HK) are up around 20% YTD. However, Tencent produced this return with a 43% annualized volatility, while China Mobile has only 25% volatility (Hang Seng Index also 25% volatility).

In fact, 15 of the top 20 SOEs listed in Hong Kong have outperformed the Hang Seng Index YTD, some by as much as 30%! What is going on?

For reasons to be discussed, we think this “state-owned alpha” is likely to continue, making Chinese SOEs prime candidates for trading.

Note many state-owned companies are dual-listed in China (A-shares) and Hong Kong (H-shares). We’ll focus this series on H-shares only.

Sector or Ownership?

This private vs. state-owned stock disparity may be a sector rotation in disguise. Some believe it’s really about the sector not the ownership structure.

Below is a comparison of the YTD returns of top five Internet companies (-1.3%) vs. top five telecom companies (+23.5%). Note the Chinese Internet sector is all privately owned, while the telecom sector is almost entirely state-owned, and so are banking, energy, utilities, transportation, construction…and soon real estate!

From the table above, it's hard to say what the real logic is: do investors shun Internet stocks because of Internet or the companies’ private ownership? Likewise, do investors favor telecom because of telecom or the government ownership?

I think sector, size and ownership all play a role here.

In banking, large central state-owned banks easily outperform the small, private or local state-owned banks. For example, ICBC (1398.HK), the world’s largest bank, is up 5% YTD while local banks like Bank of Guizhou (6199.HK), China Bohai Bank (9668.HK) and Harbin Bank (6138.HK) are all down 20-30% YTD. The intra-sector spread is well over 20%.

It is also rare for a “boring” company like ICBC to outperform the market (Hang Seng Index +0.68% YTD).

What’s Not Changed

Let’s dig deeper to see what the real change is with Chinese SOEs.

China’s SOE reform dates back to the 1980s. It has been a painful long process making what Chinese SOEs are today, from small, inefficient companies to large but still inefficient companies. We didn’t expect major changes to SOEs’ earnings growth and return-on-equity before, and we don’t expect such changes now.

For example, China Mobile’s ROE gradually declined in the last 10 years and only recovered recently to about 10% in 2022. Its earnings growth was low single digits in a good year (+3.7% in 2022), and down single digits in a bad year (-9.4% in 2019). Not a whole lot of earnings volatility.

Given its large revenue base, high penetration, matured market and government ownership, it’s difficult for China Mobile to change its fate: an elephant that really can’t dance. This is the part that’s not changing.

Next let’s see what’s actually changing that make SOEs special in today’s environment. To be continued…

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