DOW JONES INDEXES SEPTEMBER 2002 CHINA STOCK MARKET IN A GLOBAL PERSPECTIVE Research Report by Executive Summary Sheldon Gao, PhD. China’s stock market has experienced amazing growth since establishing its two Senior Director, Dow Jones exchanges in 1990, although the growth has been uneven and irregular, and the Indexes market remains in the early stages of its development. This report seeks to identify 609-520-4114 the key characteristics of China’s market and how they combine to form the most [email protected] dynamic and intriguing developing market in the world. The current structure of China’s market is one of its key obstacles to further develop- ment. There are very few stocks that would fit the definition of “blue-chip” trad- ing on China’s mainland exchanges. Whereas most developed markets are domi- nated by a limited number of large-cap stocks, China’s market is cramped by a multitude of small-cap stocks. This feature allows for increased speculation and higher turnover for both investors and indexes, among other problems. A related matter is the reliance of China’s market on external expansion, that is, expansion through the issuance of new shares rather than the appreciation in value of existing stocks. Since these shares generally do not experience sustained growth, often because of market manipulation, they contribute to the dominance of smaller size stocks in China’s market. Ultimately, the current structure is a major obstacle to the creation of viable index-related products in China. Another issue is the fact that, despite the tremendous growth of the stock market, China’s companies are not operating at a high level of profitability. They are plagued by poor earnings and low dividend yields. China’s companies need to increase their profitability if they are to compete in global markets. Finally, government seems to have too much influence on the market. It keeps a tight control on the issuance of IPOs, and, as a result of widespread government hold- ings, many listed companies in China have very low free-float ratios. Meanwhile, due at least in part to the unusual market structure, market manipulation and speculation are common. The solution is simply a matter of strengthening controls in certain areas while relaxing them in others in order to foster an environment in which China’s stock market can continue to thrive. DOW JONES INDEXES September 2002 4 Introduction 6 Abnormal Performance 9 Tremendous Volatility ONTENTS C 12 Insulated Market 14 Substantial Government Ownership 17 Irregular Expansion 19 Influence of IPOs 21 Typical Emerging Market 24 Pyramid Structure 30 Unstable Core 33 Outperformance of Micro Stocks 36 Incredible Speculation 38 Manufacturing Orientation 40 Disappointing Earnings of Companies 44 Low Dividend Yield 47 Conclusions 6 Performance of Major Indexes Worldwide (1994—2001) 7 First Eight Years of the Dow Jones China Index ABLES T 8 Ten Biggest Up and Down Days in the China Market 8 Crucial Role of the Ten Best Days in the China Market 9 Performance of China Indexes in Domestic and Overseas Markets 10 Volatility of Major Indexes Worldwide (1994—2001) HARTS AND 11 Bull and Bear Markets in China (1994—2001) C 11 Bull and Bear Markets in the U.S. and China (1896—2001) 13 Annual Return of Major Indexes Worldwide 13 Correlation Between Major Indexes Worldwide 14 Tracking Error Between Major Indexes Worldwide 15 Float Ratios of Major Stock Markets Worldwide 15 Free-Float Ratios of the China Market (%) China Stock Market in a Global Perspective 2 DOW JONES INDEXES September, 2002 ) 16 Float Ratio vs. Stock Return in China’s Market 16 Government Ownership in the U.S. and Japan 18 Stock Market Expansions in the U.S. and China CONTINUED 19 The Role of IPOs in the U.S. and China Stock Markets 20 IPO Change vs. Index Performance in China’s Market ABLES ( 23 Shareholder Statistics in the U.S. and Japan Stock Markets T 24 Correlation Between Major China Indexes 25 Market Concentration Measured by % of Stocks 26 Market Concentration Measured by # of Stocks 26 Market Coverage of Dow Jones Country Titans Indexes HARTS AND 27 Market Coverage of China Stocks (January 31, 2002) C 27 Comparison of Market Concentration in China and Rest of the World 28 Tracking Error Between Major China Indexes 29 Stock Number: Dow Jones Global Indexes and China Indexes 30 Turnover Rate of Blue-Chip Indexes in Market Value 31 Turnover of Blue-Chip Indexes in Number of Stocks 32 Benchmark vs. Blue-Chip Indexes in China 33 Performance Comparison of China Indexes (1994 – 2001) 34 Composite Index vs. Stock-Selected Index in a Global Market 35 Performance Comparison of Benchmark vs. Tradable Indexes 37 Turnover Comparison of Several Stock Exchanges 38 Comparison of Sector Representation 39 Sector Representation of China’s Stock Indexes 40 P/E of Blue-Chip Indexes in Several Major Markets 42 P/B of Blue-Chip Indexes in Several Major Markets 43 P/E and P/B of TOPIX in Japan 43 Ratio of Stock Market Capitalization Over GDP in China 44 Summary of Index Payout Percentage Over the Past Two Years 45 Payout Ratio and Dividend Yield of Some Blue-Chip Indexes 47 Comparison of Several New Emerging Markets China Stock Market in a Global Perspective 3 DOW JONES INDEXES September 2002 Introduction China’s stock market has grown China’s stock market has experienced tremendous growth and development with amazing rapidity since the in the ten years since the inceptions of the Shanghai Stock Exchange establishment of its two exchanges (December 19, 1990) and the Shenzhen Stock Exchange (December 1, 1990). in 1990. However, that growth has The number of listed companies reached 1,160 at the end of 2001 — up from been extremely irregular and has only 10 companies in the early 1990s — with a total market capitalization of not followed traditional models of 525.6 billion USD. In addition, more than 65 million investment accounts are stock-market development. In many ways, it is still in the early stages on record as of the end of 2001. of development. However, two sets of phenomena have been identified in media reports. One is the rapid growth of the stock market: almost 1,200 listed companies, swelling numbers of stock investors and the generally upward trend of the local stock indexes all indicate that the basic shape of a large country’s stock market has formed. The other set of phenomena also deserves the same attention: an incomplete corporate-governance structure, inadequate regula- tory capacity, intrinsic structural defects of the market, ferocious market manipulators and all kinds of traps. In other words, China’s market is still in the early stages of development. Building a solid foundation and appropriate structure is pivotal to the consistent long-term growth of China’s financial market. People have been trying to understand this paradox, but have failed to figure out precisely the growth and decline of these two components. This has made it difficult to unravel the mystery of China’s stock market. For instance, how high is the price-to-earning ratio (P/E) in China’s market and what kind of stocks have been the driving power of the market? Furthermore, is China’s market ready for financial derivative products? On May 26, 1996, the one-hundredth anniversary of the Dow Jones Industrial Average (DJIA), Dow Jones & Company introduced its China index series. The first China index series developed by a global index provider, it consists of four indexes. The Dow Jones Shanghai and Shenzhen Indexes cover about 80% of the market capitalization of the Shanghai and Shenzhen Stock exchanges, respectively. The Dow Jones China Index, the composite of the Dow Jones Shanghai and Shenzhen indexes, tracks the general trends in China’s stock market. The Dow Jones China 88 Index, a tradable index designed specifically for investment products and derivatives, is made up of the 88 largest and most liquid stocks. With a base value of 100 as of the base date of December 31, 1993, for each of its indexes, the series includes only class A shares, which are restricted to domestic Chinese investors. China Stock Market in a Global Perspective 4 DOW JONES INDEXES September, 2002 Since the Dow Jones China index series is constructed according to the same rules and concepts as the Dow Jones Global Indexes (DJGI), it provides a unique platform from which to make a direct comparison between China’s market and major developed markets worldwide. Using the DJGI and the Dow Jones China Index series as tools, this article scrutinizes China’s stock market from a global perspective by comparing its structural characteristics and movement patterns with those of other markets around the world. China Stock Market in a Global Perspective 5 DOW JONES INDEXES September 2002 1. Abnormal Performance From 1994 through 2001, the China’s stock market delivered impressive returns during the eight-year peri- Dow Jones China Index outpaced od from 1994 through 2001, as measured by the Dow Jones China Index1. many of the world’s best-known The index included 549 stocks as of January 31, 2002 (282 in Shanghai and indexes. But much of that superior 267 in Shenzhen). As shown in Table 1, it outpaced many of the world’s best- performance is attributable to a known indexes, including Japan’s Nikkei 225, Hong Kong’s Hang Seng specific share class, specific days Index, the Dow Jones STOXX 600 covering Europe, and the Dow Jones and a specific year. World Emerging Markets Index that covers 11 major emerging markets around the world.