CHINA China Strategy Small-caps to Large-caps Discount Shenzhen: Connected % MSCI China Small-cap to Large-cap discount 0 4Q16 launch of Shenzhen-Hong Kong Connect both signifies an easing of -10 capital outflow concerns and provides international investors access to China’s -20 -30 most dynamic equity market. Access to A-share-listed private enterprises will -40 jump by 4x. The inclusion of ETFs and minimum market capitalisation -50 -60 requirements are the main positive and negative surprises, in our view. We -70 forecast a further 12% upside for China equities and highlight our top Hong Kong 12 04 05 06 07 08 09 10 11 13 14 15 16 - - - - - - - - - - - - - small-cap picks and Shenzhen A-share picks in this report. Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul P/B discount Average Northbound: Better growth - 1 s.d. + 1 s.d. Source: FactSet, Macquarie Research, August 2016 The launch of Shenzhen Connect will offer international investors better exposure to the high-growth parts of China’s economy. The launch expands the Breakdown for eligible northbound number of A shares that international investors can access (via Connect) by 2.5x stocks in Shenzhen Connect to 1,450 stocks, effectively encompassing all investable stocks in the A-share Consumer Utilities Energy market. Importantly, 75% of the newly eligible stocks are private enterprises Staples 2% 1% 7% versus only 38% for the Shanghai Connect. IT 22% Healthcare Southbound: Rerating of small caps 10% The expansion of the eligible Hong Kong investment list to include ETFs and the Materials Hang Seng Small Cap Index should enhance southbound flows. The HKD5bn 12% Cons Disc market cap requirement is slight disappointing in this regard, however. Since 17% 2008, the discount of HK-listed China small caps to large caps has steadily Industrials narrowed from 65% to 25%. This compares with a small-cap premium of >200% Financials 16% 13% in the A-share market. We expect Connect inflows to support further rerating of HK-listed China small caps. Source: FactSet, Macquarie Research, August 2016 SH-HK Connect southbound usage 12% upside left to index targets Widening of foreign ownership limits, of which the Shenzhen Connect is an RMB bn SH-HK Stock Connect quota usage important component, is one of our six catalysts for upside to China equities this 300 Southbound quota = RMB250bn year. H-shares and A-shares have rallied 28% and 18%, respectively, from their 250 lows in February. Our index targets published in February (Year of the Eagle) 200 remain unchanged and offer 12% further upside to both indices, representing par 150 to book value for the H-share index and a 50% premium for the A-share index. 100 50 Top picks 0 Our 21 top picks in the Hang Seng SmallCap index offer an average 40% upside 15 15 14 14 15 15 15 16 16 15 16 15 16 15 15 16 16 15 16 15 15 16 - - - - - - - - - - - - - - - - - - - - - - to our target prices. 16 of the stocks operate in areas with strong secular growth: Jul Jul Apr Oct Apr Jan Jun Jan Jun Mar Mar Feb Feb Dec Nov Dec Nov Aug Sep Aug May May rising consumer spending, industrial upgrading and environmental spending. The Source: CEIC, Macquarie Research, August 2016 selection trades on 12x forward earnings and we are forecasting 20% earnings growth in 2017. Half of the stocks trade on single-digit earnings multiples, mostly in the renewables, oil services and property sectors. Our top Shenzhen A-share picks offer 20% to our target prices. This selection is slightly more expensive (15x forward earnings) but offers better growth (25%), Analyst(s) size (USD11b avg mkt cap), sector leadership and trading liquidity (USD55m avg Erwin Sanft per day). Globally competitive companies Midea, Hikvision, GoerTek and +852 3922 1516 [email protected] Everwin are included, along with consumer leaders Yanghe Brewery, PingAn Jerry Peng +852 3922 3548 [email protected] Bank, ChangAn Auto and Rapoo. 18 August 2016 Macquarie Capital Limited Please refer to page 30 for important disclosures and analyst certification, or on our website www.macquarie.com/research/disclosures. Macquarie Research China Strategy Shenzhen: Connected 2.5x expansion of A- Details of the Shenzhen Connect were announced by the Hong Kong Exchanges following share access the State Council’s approval of the mechanism. The actual launch will happen within the next four months, once final testing and rule amendments (eg, taxation) are completed. 4x increase in access to private The northbound eligible stock list will constitute the Shenzhen Component Index and enterprise sector the Shenzhen Small/Mid Cap Innovation Index. Stocks with market capitalisation below Rmb6bn will be excluded. This represents a 2.5x expansion of the number of A Inclusion of HK shares that international investors can access (via both Connect programs) to 1,450 small caps stocks, effectively encompassing all investable stocks in the A-share market. The southbound eligible stock list is being expanded to include the Hang Seng Composite SmallCap Index. Stocks with market capitalisation below HKD5bn will be excluded. This represents a 30% expansion of eligible Hong Kong stocks to 420. All remaining dual-listed stocks in Shanghai and Shenzhen that were outside the Connect will now be included. We have included a list of A-H premiums in the appendices of this report. ETFs will be included for the first time in both Connect programs but roll-out is planned for 2017, after the launch of Shenzhen Connect. The daily quotas for the Shenzhen Connect will be the same as for the Shanghai Connect. Aggregate quotas – which were close to being full in the case of southbound Shanghai Connect - will be abolished. The main wrinkle we see in the Shenzhen Connect is the exclusion of stocks with market capitalisation lower than HKD5bn from southbound, and lower than Rmb6bn for northbound. While there may be genuine reasons to limit northbound flows into overvalued Shenzhen micro caps, the same rationale doesn’t make sense to us in the case of undervalued HK small caps. Introducing this rule eliminates 43% of the Hang Seng SmallCap index from inclusion. Fig 1 Key Features of Shanghai & Shenzhen Connect Source: HKEX, Macquarie Research, August 2016. Estimated data as of end July 2016 18 August 2016 2 Macquarie Research China Strategy Fig 2 MSCI China Small-caps P/B Std-dev and ROE Fig 3 MSCI China Small-caps Discount to Large-caps PB Price/Book ratio Average P/B % % MSCI China Small-cap to Large-cap discount 4 - 1 s.d. + 1 s.d. 12 0 Annualized ROE (RHS) -10 10 3 -20 8 -30 2 6 -40 -50 4 1 -60 2 -70 04 05 06 07 08 09 10 12 14 16 11 13 15 - - - - - - - - - - - - 0 0 - Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul 04 07 08 09 10 11 14 15 16 05 06 12 13 - - - - - - - - - - - - - P/B discount Average - 1 s.d. + 1 s.d. Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Source: FactSet, Macquarie Research, August 2016 Source: FactSet, Macquarie Research, August 2016 Fig 4 Sector breakdown for eligible northbound Fig 5 Sector breakdown for eligible northbound stocks in Shanghai Connect stocks in Shenzhen Connect Telecommunic Utilities Energy Cons. Stap. 2% ation Services Health Care 1% 4% Consumer 0% 4% Staples IT 7% Utilities 4% 5% Healthcare Information 10% Technology 22% Energy 7% Financials 41% Materials Materials 7% 12% Consumer Discretionary 17% Cons. Disc. Industrials Financials Industrials 9% 19% 13% 16% Source: FactSet, Macquarie Research, August 2016 Source: FactSet, Macquarie Research, August 2016 Fig 6 Shanghai Connect vs Shenzhen Connect Shanghai Connect Shenzhen Connect (exp.) SH HK SZ HK Total MktCap (US$bn) 3,258 4,006 2,467 4,429 # of Firms 567 318 872* 424** Average mktcap (US$mn) 5,745 12,598 2,829 10,446 % SOE 62% 44% 25% 34% Average PE 20.9 13.0 48.4 16.2 *Including dual-listed stocks but excluding stocks with market cap less than RMB6bn. Total number of stocks in SZSE Component and SZSE Small/Mid Cap indices is 1,000. ** Including Hang Seng Composite LargeCap, MidCap, SmallCap (market cap larger than HK$5bn) indices & dual-listed shares. Source: Wind, FactSet, Macquarie Research, August 2016, prices as of 16 August 2016 18 August 2016 3 182016 August Macquarie Research Fig 7 Hong Kong small-cap top picks Company Name Ticker Analyst MktCap 3M Daily % EPSg P/E PB ROE % DivYld Net Performance Target Current Upside T/O Gearing (US$m) (US$m) 2016 2017 2016 2017 2016 2016 2016 2016 % YTD Price Price % Fuyao Glass 3606-HK Leo Lin 6,808 3.4 8.9 14.2 15.1 13.2 2.6 17.6 4.3 0 12.7 23.00 21.1 9.3 Goldwind 2208-HK Patrick Dai 6,587 5.9 15.7 2.2 8.8 8.6 1.6 18.7 5.3 56 -16.4 13.00 12.5 4.3 Huadian Fuxin Energy 816-HK Patrick Dai 2,190 3.2 16.9 16.5 6.5 5.6 0.7 11.5 2.7 300 -9.0 2.60 2.0 28.7 China High Speed Trans. 658-HK Patrick Dai 1,432 6.2 5.5 -3.1 8.7 9.0 0.8 10.7 3.3 60 8.8 6.80 6.8 0.1 Fu Shou Yuan 1448-HK Timothy Lam 1,394 1.5 12.3 9.4 30.9 28.3 3.9 13.1 0.4 -43 -14.4 6.50 5.2 26.0 Yuzhou Properties 1628-HK David Ng 1,245 1.6 23.0 22.8 5.9 4.8 0.8 15.5 5.9 77 20.5 3.10 2.5 22.5 Li Ning 2331-HK Terence Chang 1,194 5.7 2,900.7 28.2 18.1 14.1 2.7 16.3 0.0 -40 16.9 5.10 4.9 3.9 Kingdee 268-HK Hillman Chan 1,058 5.4 94.5 34.6 38.9 28.9 2.0 5.6 0.0 -26 -21.6 3.50 2.8 25.4 ChinaSoft 354-HK Timothy Lam 1,006 5.2 7.5 23.7 21.6 17.5 1.7 8.9 0.0 26 12.5 3.85 3.6 6.6 TCL Multimedia 1070-HK Louis Cheng 938 1.0 750.5 23.5 25.0 20.2 1.2 5.0 0.0 47 -14.8 6.00 4.2 43.2 Haichang Ocean Park 2255-HK Timothy Lam 830 0.2 162.9 7.8 21.7 20.2 1.4 6.4 0.0 72 -7.5 2.25 1.6 39.8 Tianneng Power 819-HK Timothy Lam 821 2.8 16.4 23.0 7.6 6.2