When it comes to finding investments, knowing where to look can be half the battle. At KIS, one of the things we like to look for are industries with strong structural growth tailwinds. The rationale behind this boils down to one simple fact; it is easier to grow one’s earnings with the tide, rather than against it.
In industries where structural growth is benign or non-existent, companies must take market share from their competitors in order to grow revenues. Alternatively, companies that operate in growing industries need merely to maintain their market share to increase revenues, and ultimately, profitability. To us at least, the latter seems a far more manageable proposition.
One industry that currently presents such an opportunity is the Chinese broker market. These companies are highly leveraged towards Chinese A-share activity, which has recently seen strong upticks in key indicators, suggesting a turn in the cycle. On a longer-term time horizon, we see the continuing deregulation of capital markets in China as a solid structural growth driver over the coming years.
Chinese equity markets have been a bumpy ride in recent times. Government deregulation of short selling and margin lending led to a leverage-fuelled bubble that peaked in mid-2015. Following a harsh market correction later that year, equity markets have been somewhat stagnant. Subsequently, the key indicators of market activity, being average daily turnover (ADT), margin financing balances, and SHCOMP index performance, have all been relatively weak. We view this weakness as temporary, however, with strong structural proponents likely to increase business for Chinese brokers in the near term.
ADT is a solid indicator of a broker’s brokerage earnings – the more trading there is on an exchange, the more commission a broker can make as they ‘clip the ticket’ on trades. ADT has two important structural drivers; growth in household financial assets (how much money people have available to invest), and the relative attractiveness and supply of alternative investment classes. Since 2011, personal financial assets in China have grown at a stellar CAGR of circa 18%, reaching over Rmb116tn in 2016. If the allocation of wealth to each asset class remains proportional, growth in personal financial assets should lead to increased ADT as excess wealth is allocated towards equity markets. Unfortunately for the brokers, this hasn’t been the case. Allocations towards equity have fallen since the 2015 market correction, largely offsetting the growth in personal wealth over the last two years. We don’t expect this trend to continue. Increasing regulation of alternate investment classes, most notably that of high-yielding, non-standardised credit assets, should reduce the opportunity set available to Chinese investors, thus improving the attractiveness of equity as an asset class. The recent upwards trend in ADT supports this, suggesting that the cycle has begun to turn, with ADT for September up 33% on the previous year.
A similar recovery has been seen in margin financing balances as well as the SHCOMP index performance. Margin financing balances reached Rmb985bn in September, up 13% year-on-year, with the SHCOMP reaching yearly highs as well. Both of these will serve to bolster broker performance if trends continue into next year.
Furthermore, expected deregulation of oil futures contracts should provide a new profit centre for brokers. Any slice of this trillion-dollar market would be a material contributor to their commodity futures divisions. This is just one example of the Xi government’s continuing support of capital markets in China, attempting to rebalance an economy that has traditionally relied upon credit-fuelled stimulus. These reforms provide Chinese brokers with a strong, long-term structural growth driver.
Once an industry with structural growth has been identified, a bottom-up analysis can then be conducted to determine which companies offer the best investment opportunities. There are a variety of factors to be considered; operating history, balance sheet strength, valuation, and exposure to the structural growth factors, just to name a few. Depending on the circumstances, it may be appropriate to invest in a small selection of companies, limiting idiosyncratic risk whilst also attempting to realise returns above that of the industry. So which brokers offer the most attractive investment profiles?
CITIC Securities (6030.HK) is our top pick of the litter, offering a balanced exposure to brokerage and investment returns. The company’s market leading position also gives it strong upside optionality in its potential exposure to oil futures contracts. China Galaxy Securities (6881.HK) is another attractive offering, as it has the greatest leverage towards increases in ADT – Galaxy derives 40% of its revenues from brokerage, the highest percentage contribution of any listed Chinese broker. Haitong Securities (6837.HK) is another interesting one. Its revenue stream is more resilient than its peers, with a higher proportion of earnings derived from overseas ventures. Haitong’s return on tangible capital employed currently sits at depressed levels, leaving plenty of room for improvement. On the valuation front, all three of these brokers offer compelling P/E and P/B ratios. This is relative both to historical valuations, as well as to the rest of the market. Put another way, these brokers are priced for a continuing market deterioration, offering downside protection if the market doesn’t recover, and upside optionality if it does.
Chief Investment Officer at KIS Capital