China’s market has soared in 2019, but it’s only the beginning
What if I told you there was an investment that was guaranteed to see tens of billions of new inflows this year? And you can invest in it right now before all those billions push up the stock price.
Almost sounds illegal, right?
It’s not. It’s perfectly legal … it’s actually happening … and you and I can place our money now before those billions flow in.
In all likelihood, this is as close to crystal-ball investing as you’ll ever get.
So, what exactly is happening?
***Last Thursday, MSCI announced that it will be quadrupling the weighting of Chinese mainland shares in its global benchmarks
MSCI is one of the world’s largest index providers. You might recognize it as the provider of the MSCI BRIC, EAFE, and World indexes.
The impact of this decision is huge — potentially $80 billion of new foreign money is going to flow into the Chinese stock market this year.
We’ve been given a crystal ball. We know where billions of dollars are headed — and we can get there first.
***Before we go any further, let’s make sure we’re all on the same page about what’s actually happening and how it works
When you research stocks for your portfolio, trying to identify the ones most likely to race higher, you’re what we call an “active investor.” It’s the same for a professional fund manager. When a manager takes a hands-on approach, personally selecting the specific investments to buy and sell for a portfolio, that’s an “active” approach.
The opposite is a “passive” approach. That’s when you, or a professional fund manager, takes a position in an investment and then simply hangs on for the long haul. It’s more of a “buy-and-hold” strategy.
A recent report found that passive investments account for nearly 45% of all equity assets in U.S. mutual funds and exchange-traded products. In the chart below, you can see that this number has been steadily climbing for years, not just in the U.S., but around the world as well.
Now, many passive investors make use of index funds. An index fund is a single investment that tracks the performance of an overall market or sector. For instance, if I wanted to buy a single investment that mirrors the S&P 500, I could buy “SPY.” That one ETF would give me exposure to the averaged performance of the companies from the S&P 500.
Index funds have become incredibly popular. An article from Reuters reports that index funds will represent more than half of the assets in the investment management business by 2024 — at the latest.
The point here is that massive — and growing — quantities of wealth are tied up in passive, index investment products. So, if a popular index changes what it includes, say, by adding a new investment, then the massive volume of wealth that tracks the index is going to pour into that new investment.
This is an important point, so let me repeat: when an index changes its holdings, all the other investment products that track the index typically make that same change themselves.
And when that happens, would it be fair to expect that all of that focused wealth might push up the price of that new investment?
***This is the exact dynamic that’s about to happen with Chinese stocks
Last week, we learned that domestically listed Chinese stocks (what are called “A Shares”) will increase to 3.3% of MSCI’s emerging-markets benchmark by November. Right now, their weighting is just under 1%.
This is a huge move. It means billions of dollars that track this index will be flowing toward China. Specifically, MSCI expects it will drive nearly $80 billion more into the Chinese market.
This is going to happen because passive funds that mimic the MSCI Emerging Markets Index will be compelled to add more domestic Chinese stocks to portfolios. Even some active managers that use the MSCI index as a benchmark may feel it’s necessary to add additional Chinese exposure.
The deputy head of China’s securities regulator predicted this will double foreign capital inflows into Chinese stocks — this year alone.
But it doesn’t stop there. Rival index publishers FTSE Russell and S&P Dow Jones will both begin adding Chinese shares to their global benchmarks later this year.
***And there’s no reason to believe that MSCI won’t continue to increase its index exposure to China in the future
From MSCI’s website:
Investors can access the Chinese equity market through several share classes, the largest being A shares. MSCI started to partially include China large-cap A shares in the MSCI Emerging Markets Index on May 31st, 2018. Under the current partial inclusion plan, China A shares will have a weight of 5% this year (split into two phases). In the event of full inclusion, China equities would exceed 40% of the MSCI Emerging Markets Index [1].
Two things about this … First, this information is dated. It tells us that China A shares will have a weight of 5% this year. But last week’s news has already bumped this 5% to 20%!
Second, notice that “1” footnote? Here’s what that footnote reads:
China would comprise 31.3% of the MSCI Emerging Markets Index at 5% inclusion as of August 2018 … At a hypothetical 100% inclusion (which may or may not occur in the future), China would comprise 42% of the index …
Now, if MSCI has already confirmed it will be quadrupling its China holdings from 5% to 20%, what reason do we have to believe there won’t eventually be a full-inclusion? As you can read above, that would mean China receives a 42% weighting of the MSCI index.
That’s tens of billions of additional dollars that could be flowing toward China over the coming years.
***But hasn’t China’s market soared already in 2019? If I’m not already invested, am I too late?
Chinese stocks have been on a tear, that’s undeniable. And we hope you’ve been a part of it, given how we put a China trade on your radar back in our February 4th Digest:
Meanwhile, another trading opportunity is setting up for investors who are comfortable with more risk.
After taking a beating in 2018, it looks like Chinese stocks have carved out a bottom.
When a sector or country suffers a major selloff but then stabilizes like China did in 2018, it goes a long way towards “de-risking” a long position. In other words, the sector or country is much less likely to experience additional, major declines at that point.
Overall, we love to see this pattern of “down big, hated, formed a base, and now breaking out to the upside.” It’s one of the best trading set-ups you can hope for.
At the time of this writing, one of our suggestions, KBA, is up over 17% since our recommendation.
And yes, these gains are huge for such a short period. But here’s what important to remember — these gains don’t reflect the additional tens of billions of dollars that will be flowing to China given the MSCI news.
In other words, the Chinese market is up big. But new money is on the way.
***So, how could you play this?
As our February 4th Digest identified, KBA is the KraneShares MSCI China A ETF. It will give investors exposure to the MSCI inclusion event that’s happening.
But two of our analysts see other ways to play China — specifically, by focusing on fundamentally-strong tech stocks.
I recently sat down with veteran Eric Fry, editor of The Speculator. Regular Digest readers will recognize Eric’s name, as over the last several weeks, we’ve been featuring some tremendous calls he’s made that have resulted in his subscribers banking huge returns using options.
In my interview with Eric, which was before the latest MSCI news, I asked him about Chinese stocks. Do the gains in the broader Chinese market, coupled with China’s economic slowdown, mean the best is behind us?
From Eric:
I think you’re going to see specific sectors that are going to do very well. Take Chinese internet stocks, for example. I think they will do well, at least relative the overall Chinese market, even if the Chinese market itself is not doing a heck of a lot.
Matt McCall shares a similar view. Matt tracks the massive trends that are re-shaping our world and the investment markets through his newsletter, Investment Opportunities.
Matt holds several Chinese tech stocks in his portfolio. He points toward their attraction valuations and growth expectations relative to their U.S. peers.
On the topic of China’s valuation, a recent Wall Street Journal article notes:
The broad Chinese market trades at just 14 times forecast earnings for the next 12 months, according to a FactSet index of more than 3,000 stocks. That is roughly 17% below its 10-year average of 16.8 times, despite a blistering rally in Chinese stocks over the first two months of this year.
On other gauges, the country looks even cheaper: The MSCI China A Onshore Index, which includes large- and mid-capitalization stocks in Shanghai and Shenzhen, had a price-to-earnings ratio of just 10 times at the end of January.
That said, some Chinese tech valuations are higher. That means it’s important to know what you’re buying and why if you decide to buy specific stocks rather than an ETF.
If you want help identifying specific Chinese winners from Matt, you can learn more here. If not, it’s helpful to know that some Chinese tech stocks will be included in the MSCI broad index.
For instance, Tencent and Alibaba — both huge Chinese tech companies — each make up over 4% of the MSCI Emerging Markets Index. That’s a major weighting.
Whatever your preference — an index that tracks the broader Chinese market, or targeted exposure to specific Chinese tech companies — the takeaway is the same …
Tens of billions of dollars are going to be funneling into the Chinese stock market. You have the chance to get in ahead of it.
We’ll continue to keep you updated.
Have a good evening,
Jeff Remsburg
