Completing Your China Exposure: Small Companies Help Capture China's New Growth Drivers

As China’s economy continues its shift toward services and consumption, small- and medium-size businesses are accelerating this transformation. China’s entrepreneurs are introducing new business paradigms, disrupting old ways of doing business and laying the groundwork for outsize growth opportunities. For investors seeking alpha, China’s small caps may present a compelling opportunity. We believe low research coverage in the market leaves the field open for finding undiscovered companies with untapped growth potential. Furthermore, the domestic focus of small companies can provide an element of protection against trade tensions and other geopolitical macro risks.

Many investors today may already have exposure to China via investment strategies tilted toward larger companies. For investors specifically looking to access China’s dynamic growth potential, adding exposure to small companies can help complete a China allocation. China’s small caps can help improve diversification by providing access to a universe of companies with little to no overlap with most developed or emerging markets (EM) benchmarks. With attractive Sharpe ratios relative to emerging markets, China’s small caps can help improve the broader risk/reward profile of an overall portfolio. Additionally, China’s small caps have historically been less risky than many investors may expect—volatility for China’s small caps is similar to U.S. small caps, and have historically been less volatile than China’s large caps over the long run.

Valuations for China’s small companies remain near the lower end of their historical range, which we find an appealing entry point for investors who believe in the long-term secular growth potential of China. We expect the gap between small and large companies to narrow over time as investors take a closer look at the quality and growth trajectories of China’s small companies. Quality metrics of many small caps, including high return on equity, are positive and many companies generate a solid return on their assets, together with attractive earnings-per-share growth opportunities. Finding the top-quality companies in the universe of China’s small caps requires an active approach, however, as not all small companies are value creators. Here are some of the reasons we believe that China’s small companies deserve a closer look.

Entrepreneurs Drive China’s New Economy

Small-cap companies in China are at the forefront of the country’s economic shift away from fixed asset investments such as manufacturing, infrastructure and real estate, and toward innovation, consumption and services. China’s smaller companies tapping into the entrepreneurial spirit across cities and provinces tend to thrive mostly in productivity- and value-enhancing industries such as automation, health care, e-commerce and education. These areas are under-represented in large cap-oriented benchmarks and portfolios. Small-cap companies have the entrepreneurial spirit and flexibility to recognize and respond to changing local market trends, including changing patterns of consumption. We believe China’s transition to entrepreneur-driven growth could lead to value creation and attractive investment opportunities among small caps.