Blue chip quality?

Journalist Charles Dow founded his famous index on May 26, 1896, with the intention of creating a “window” on the stockmarket and the wider economy.

He chose 12 companies that he thought representative of America’s burgeoning industrial sector. The index began life at the lowly level of 40.94, growing to its current number of 30 constituent stocks in 1928. In the decades that followed it measured the performance of America’s evolving ‘blue chip’ shares, with older member stocks such as Tennessee Coal & Iron being replaced by the likes of IBM.

As Dow had hoped, the index became a way for Main Street to understand Wall Street better, and as shorthand for checking the health of the American economy.

In early 2017 a fund manager approached WiC with an idea. He had been buying Chinese A-share stocks and lamented there wasn’t a simple ‘blue chip’ index like the Dow Jones Industrial against which he could benchmark his performance.

The Shanghai Composite, probably the most quoted index in China, has often been accused of being an unhelpful way to track A-share performance. That’s why another media firm, the Chinese state broadcaster CCTV, has attempted to create an alternative benchmark for A-shares (see WiC166). But the fund manager felt the other indices were too complicated for many investors; containing too many companies that were not what he deemed ‘investable’.

His suggestion was a simpler 30- stock index of ‘blue chip’ A-shares drawn from the best of the locally listed companies in Shanghai and Shenzhen. The idea was that the group should mirror the Dow in its simplicity. Like the original Dow the choice of the constituents could draw on a journalistic selection process to screen the firms for ‘blue chip’ status. The investor, who had been a reader of Week in China since its inception, said we should make the choice of companies ourselves and then see what happened to the index.

We liked the idea and got to work…

How did we create the WiC30 A-Share Blue Chip Index?

The idea of putting together a blue chip benchmark from close to 3,000 A-shares on China’s two bourses in Shanghai and Shenzhen was a daunting one. By reputation the A-share market has been described as something of a casino, dominated by smarter insider money, with a much larger herd of retail investors joining the chase as the next speculative theme arose.

Choosing blue chip entities was not a straightforward exercise. But we had an advantage: we’d written thousands of articles on 1,600 Chinese companies and had some editorial perspective on what we deemed as the good, the bad and the ugly in the corporate sector.

When we sat down to whittle down our selection, we began with 100 of the biggest A-shares by market value. We then made a couple of key decisions. First, like the Dow Jones Industrial, we would not weight our index by the constituent firm’s market capitalisations. Instead we opted to give equal weighting to all 30 of the companies we chose.

This was an important consideration because of our second key decision. We took the view that no index could be representative without the inclusion of China’s financial services behemoths. But these firms were so large that they would skew any index weighted by market capitalisation – meaning that any top 30 performance would be disproportionately driven by their shares.

These companies were also all state-owned and another goal for the index was to choose blue chips from more of a private-sector background.

So we made an arbitrary decision: we would cap the financial services sector at 10% of the index, or just three constituents. We chose two of the largest banking groups (ICBC and Bank of China) and a major insurer (PICC).

That left 27 other picks. Here we faced two more dilemmas. One was how to define a blue chip. The other was how to ensure the top 30 included a representative sample from the key sectors driving the Chinese economy.

In the first case we used a rule-of-thumb: will this company be around in 10 years; will it still be growing and profitable, and thus still investable?

To help our predictions, we looked at areas like corporate governance, dividend policy, the ownership background (often a tycoon) and the longer-term viability of the business itself.

The second issue was another major challenge. We decided that there had to be strong representation from sectors like consumer goods, carmaking (particularly electric vehicles) and industries such as healthcare and pharmaceuticals. These ended up making up about a third of the index. Property is also such a large driver of the Chinese economy that we felt there had to be at least one real estate developer (a huge decision for the index, it turned out). Transport and infrastructure, as well as the power and industrials sector, also needed representation, we thought.

Probably the toughest area to make selections was the technology sector, however. The A-share market gave us several choices of technology firms making hardware, although judging which of them would still be thriving in 10 years time was not as straightforward as identifying a consumer brand that was here to stay (and so it proved: our worst performer was a tech hardware firm that got into financial problems; see here).

Aside from this, another issue was that (at that time) the A-share market wasn’t a favoured venue for China’s most exciting tech firms to sell their shares, particularly its internet companies (the likes of Baidu and Tencent were listed in New York and Hong Kong respectively, for instance).

So from the outset we knew this particular component of China’s tech universe would not only be underweight but utterly unrepresented in our selection.

In the end we settled on 30 companies. We were confident that most of them passed the parameters that we had set ourselves, although there was a handful we were less sure of.

However, like the compilers of the Dow Jones index, we consoled ourselves that we could periodically rotate out the underperformers (or firms that no longer deserved blue chip status) in favour of newer candidates as more firms listed on the A-share market.

So how did the index perform?

Now an admission. For a variety of reasons we never formally launched the index. Promising although the idea was, we let it go dormant.

After conversations with another fund manager in the middle of this year, our interest in the exercise was reactivated. After four years of existence, how had the benchmark actually performed, we wondered?

Well, you could say the WiC30 served its purpose as a diversified benchmark: 18 of the constituent firms rose in value over the period, while 12 fell. Launched four summers ago with a value of 30 on August 24, 2017, the index dropped to 27.33 a year later, before rising to 33.48 in 2019 and reaching 46.78 on August 24 last year. It had fallen back slightly to exactly 45 when measured on August 24 this year.

That meant that over the four- year period the index returned about 50%, or a respectable 12.5% per annum. This is actually an underestimate of its total return as it excludes dividends (most of the stocks in the WiC30 paid low single digit dividend yields, with the highest offering 7.15%). But how does this look versus other key benchmarks? The Dow is a good place to start, given its ‘blue chip’ inspiration for our own index, and the identical number of constituent stocks. It did marginally better than the WiC30. Helped by the Fed’s continuing asset-buying spree, the Dow Jones Industrial Average (the modern-day version of the original idea from Charles Dow) surged more than 60% during the same period.

Closer to home the Hang Seng Index (HSI) was down about 9% during the same four-year period (the more recent underperformance of Hong Kong stocks was exacerbated by Beijing’s crackdown since last Novembers on the internet sector, which means that HSI heavyweights such as Tencent, Alibaba and Meituan have suffered badly).

Meanwhile, the Shanghai Composite gained just 6%. This massive index has around 2,000 stocks, and comprehensively captures every sector of the A-share market – good and bad. If anything, the considerably better return of the WiC30 over the same timeframe vindicates our approach of looking for better ‘blue chip’ counters.

What were the best-performing stocks?

The best performer of the 30 was BYD with a 521% gain. The electric vehicle maker is one of only two Chinese shares in which Warren Buffett has ever invested – the other being state-owned oil major PetroChina. The decision by Berkshire Hathaway to exit PetroChina in 2007 (at a $3.5 billion profit) and switch into BYD a year later now looks classic Buffett. Nevertheless, patience was required to capitalise on the relatively recent rally in the electric vehicle (EV) firm’s stock price. BYD’s Shenzhen-listed shares spent most of the past five years hovering around the Rmb50 mark, but sprung into life in the second half of 2020, after China’s leader Xi Jinping announced new carbon neutrality goals for the economy. BYD has been perceived as a key proxy for investors buying into this policy commitment, not just as an producer of its own brand of EVs but also as a leader in battery manufacture for third parties.

The second best performer in the WiC30 was Sany Heavy (with a return over four years of 246%). The construction equipment maker is well known to fund managers and enjoyed a period as one of the market’s favourite A-shares a decade ago. Its founder Liang Wengen’s political stock was so high at that time that he was tipped to become the first private sector entrepreneur to get a place on the Communist Party’s Central Committee (a powerful group of 300 or so senior cadres).

That did not happen and Liang’s fortunes seemed to be worsening as Sany was dislodged from his home base in Changsha by its state-owned rival Zoomlion (see WiC174).

But in recent years Sany’s push into international markets has paid dividends, with its excavator sales topping the global rankings for the first time in 2020 (and earning it a long congratulatory story in the China Daily – an indicator of a return to favour).

Its share price has also rebounded strongly, helped by the upcoming spin-off of its wind turbine manufacturing unit on Shanghai’s STAR Market (see WiC537).

Kweichow Moutai came third in the performance stakes, with a 230% return. Chinese investors seem to have a deep confidence in Moutai – an iconic liquor with prestige and scarcity value – even though its share price has gone through periods of turbulence.

The shares nearly halved in early 2014, thanks to Xi’s relentless anti-corruption campaign. But that turned out to be a rare value opportunity to buy into China’s most famous baijiu brand. Popular too with foreign investors, Moutai has since grown into the country’s most valuable A-share, although as we pointed out in another article on China’s growth sectors over the last decade, its position as the market’s A-share champion might be vulnerable to government efforts to promote investment in other higher-tech sectors (see WiC522).

Another stellar performer in the WiC30 was Foshan Haitian, a sauces and flavourings firm that some analysts describe as China’s equivalent to Kraft Heinz. Haitian is a leading producer of soy sauce, a seasoning that is fundamental to Chinese cuisine. The company came fourth in WiC30 performance with a 169% return since August 2017. (If investors had bought Haitian’s shares in 2015 – about the same time that Kraft merged with Heinz – they would have enjoyed a 650% gain at the beginning of this year.)

That said, having reached a peak value of more than Rmb700 billion ($108 billion) in January, the share price of Haitian has almost halved since then. The decline, China News Weekly has suggested, is partly due to profit taking by fund managers, as well as a switch in interest to rival food industry plays like Yihai Kerry Arawana, which went public in Shenzhen in November last year.

Completing the top five is Fosun Pharmaceutical, with a 125% gain over four years. Part of entrepreneur Guo Guangchang’s insurance-to-tourism Fosun empire, the healthcare firm gained a higher profile locally and overseas after it invested $135 million with BioNTech to partner on its Covid-19 vaccine.

Which of the WiC30 weren’t such good performers?

Worst of the lot was tech hardware firm Tunghsu Optoelectronic, which dropped 80%. The story of its decline requires fuller disclosure: see the separate box on the next page. But it also epitomises the pitfalls in granting blue-chip status to a stock and then not managing the index more actively. If WiC had been more fully focused on the benchmark, Tunghsu would have been removed a couple of years ago.

After launching in August 2017, the WiC30 ran into stiff headwinds in its first 12 months. The year marked a more defined direction in policymaking in which financial stability became a pressing priority (see WiC542). Powerful tycoons including Tomorrow Group’s Xiao Jianhua and Anbang Insurance’s Wu Xiaohui were detained by the authorities (Wu was sentenced to 18 years in jail and a fine of almost Rmb10 billion; Xiao still awaits trial four and a half years after he was hauled in by investigators). The wider outcome of the campaign was an abrupt halt to a frenetic period of overseas dealmaking from Chinese companies. A push to deleverage parts of the domestic economy also began in earnest – constraining the A-share market.

The results of the deleveraging push contributed to a down-year for the WiC30 in 2018. In the longer term, it would lead to some disastrous performances for some of the more acquisitive, financially leveraged companies too. Suning is one of the examples. Despite the on-field success of its football franchises – which won the top-flight league titles in both Italy and China – there were persistent rumours of a cash crunch at the retailer (see WiC526) before it was bailed out in a rescue effort led by local governments (see WiC548).

The retailing conglomerate is another of the stocks that would have departed from the WiC30 had we been managing it more actively.

Which stocks might we have added?

Some of the newest darlings in Shanghai and Shenzhen would be compelling choices for any index compiler. For instance, Contemporary Amperex Technology (CATL), the world’s biggest EV battery maker, went public in Shenzhen in 2018. Tellingly, it has outgrown PetroChina in market value and become one of the most valuable A-shares since it listing. It would be an obvious WiC30 addition.

We would also look to add companies deemed more representative of priority areas in the technology sector, especially companies in industries with strong government backing, such as semiconductors and artificial intelligence (AI). Chipmaker SMIC’s market value was less than $6 billion prior to its delisting in New York in 2019 (see WiC454). Since coming home to float on Shanghai’s STAR Market, the value of China’s largest domestic foundry has expanded to more than $33 billion.

Other A-share returnees would enjoy instant blue chip status as far as the WiC30 is concerned too. China Mobile, the most royal of the blue chips in the 2G telecom era, is now on the verge of a secondary listing in Shanghai’s STAR Market, for instance.

Of course, Ant Group, Alibaba’s fintech unit, was days away from a trading debut in Shanghai last November as well, only for an eleventh-hour intervention from central government regulators that derailed the mega IPO. Had Ant listed, it would have been another natural candidate for inclusion in our benchmark. Other contenders, like the leading AI firm Megvii – which is also in the queue for a debut on the STAR Market – would also be prime WiC30 candidates.

In fact, as more of the Chinese tech firms opt for domestic listings – not just on the STAR Market but even on the newer stock exchange being planned in Beijing (see WiC555) – our case for a benchmark of representative blue chip A-shares grows more compelling than ever.

For those who would like to know more about the constituent stocks of the WiC30 A-Share Blue Chip Index, please contact Week in China’s Editor at [email protected]

---

© ChinTell Ltd. All rights reserved.

Sponsored by HSBC.

The Week in China website and the weekly magazine publications are owned and maintained by ChinTell Limited, Hong Kong. Neither HSBC nor any member of the HSBC group of companies ("HSBC") endorses the contents and/or is involved in selecting, creating or editing the contents of the Week in China website or the Week in China magazine. The views expressed in these publications are solely the views of ChinTell Limited and do not necessarily reflect the views or investment ideas of HSBC. No responsibility will therefore be assumed by HSBC for the contents of these publications or for the errors or omissions therein.