Limitations of CSI 300 &
HSCI due to Financials (financial sector) Skewing Results
S&P 500 Weightings for sectors as of February 2020
The S&P 500 is a good index because it’s
representative of the U.S. economy, where as China’s CSI 300 is not as good
because of the heavy weighting of financials.
This chart reflecting the sectors of the S&P
500 was taken in February 2020. You can see that Financials only make up 12.42%
of the entire pie.
An interesting thing to note in the S&P is
that in 2008, the energy sector made up 16%, in 2020, it is only 3.5%. On
February 19, when the Coronavirus outbreak emerged, panic depressed markets
around the world, resulting in energy falling more than 17%. Nearly a fifth of
the sector’s value evaporated in less than 10 days. Another thing to note is
that communication services grew from 3.2% in 2008 to 10% in 2020.
The
S&P 500 is a good proxy of the U.S economy and it is properly balanced with
better elimination mechanisms. As you can see, technology makes up a quarter
(24-25%) of the economy, which is what you would expect of a advanced and
modernized economy, and industrials make up 8.3%.
China’s
main index such as the CSI 300 index doesn’t properly reflect the underlying
economy. The Chinese government is working hard at making the stock market a
better proxy of the economy. With the CSI 300, it has companies from both the
Shen Zhen and Shanghai stock exchange but lacks companies from the Hong Kong
stock exchange. This omission is a flaw in my opinion. Since Tencent, Alibaba,
and certain companies are contributors to the Chinese economy.
CSI 300 Weightings as of April 2019
HSCI Weightings as of Feb 2020
With
the Hang Seng Composite Index, it only has Hong Kong listed companies. Notice
that the more popular Hang Seng Index, which is frequently mentioned in the
news, comprises of the top 50 companies. This is different from the Hang Seng
Composite Index, which comprises of the approximately 480 stocks which are free
float-adjusted with weightings capped at 10%; reflecting a broader and truer
range of overall market performance.
From
the 2 charts above, we can see that financials have an unreasonable weighting
of over 30% for each. However, this doesn’t reflect reality, and these
financial companies may be over leveraged and over valued by the market.
Top 10 companies by weighting for HSCI without Financial Companies
Top 10 companies by weighting for CSI 300 without Financial Companies
Notice
that for the top 10 companies, since the index calculation adopts
a free float adjusted market capitalisation methodology as
well as other performance benchmarks— Ranking is not entirely determined by a
larger market capitalization. For HSCI, China Mobile has a larger market
capitalization at 1 trillion than Alibaba at 472 million, yet Alibaba has a
4.09% weighting, and is ranked higher than China mobile.
Most
hedge funds place a benchmark, whether it is S&P 500, Dow Jones, CSI 300,
or HSCI, the most important thing is to see what your performance is annually
in comparison to the economy. Since HSCI and CSI 300 indexes both have more
than 30% of its companies in the financial sector as of 2020, it would be
important to remove them and gauge the change in percentage annually.
Which companies in
the HSCI and CSI 300 are worth studying?
To
answer the question above, we must invert.
What
will not be disrupted over the long term? Which companies will grow with in
China? Industrials will definitely drop as China becomes a services economy;
however, as consumer staples increase, certain products may not have a good
moat due to intensifying competition. There certainly will be an increase in
domestic consumption instead of exports.
There
are certain industries which may or may not be around 10 years from now, and
industries where it is winner takes all, where it is impossible to predict the
winner. These are industries we want to avoid.
What
is important? What is knowable?
The
average age of an S&P 500 company is under 20 years, down from 60 years in
the 1950s, according to Credit Suisse. The trend is accelerating and due to
disruption from technology.
Comparing
the 1955 Fortune 500 companies to the 2017 Fortune 500, there are only 60
companies that appear in both lists (see companies in the graphic above). In
other words, fewer than 12% of the Fortune 500 companies included in 1955 were
still on the list 62 years later in 2017, and 88% of the companies from 1955
have either gone bankrupt, merged with (or were acquired by) another firm, or
they still exist but have fallen from the top Fortune 500 companies (ranked by
total revenues). Many of the companies on the list in 1955 are unrecognizable,
forgotten companies today (e.g., Armstrong Rubber, Cone Mills, Hines Lumber,
Pacific Vegetable Oil, and Riegel Textile).
Economic Lessons: The fact that
nearly 9 of every 10 Fortune 500 companies in 1955 are gone, merged, or
contracted demonstrates that there’s been a lot of market disruption, churning,
and creative destruction over the last six decades. It’s reasonable to assume
that when the Fortune 500 list is released 60 years from now in 2077, almost
all of today’s Fortune 500 companies will no longer exist as currently
configured, having been replaced by new companies in new, emerging industries,
and for that we should be extremely thankful. The constant turnover in the
Fortune 500 is a positive sign of the dynamism and innovation that
characterizes a vibrant consumer-oriented market economy, and that dynamic
turnover is speeding up in today’s hyper-competitive global economy.
Let’s
look at the industries included in these two indexes.
Energy
Worth
looking into, but dependent on oil prices. Important and knowable, but might be
slightly unpredictable.
Materials
This
sector includes mining and metal refining, chemical products, and forestry
products. In my opinion, mining is hard to predict and chemical products are
cyclical. I deem this category knowable, but not important.
Industrials
Worth
knowing and studying, and extremely important. This sector might be shrinking
in the future, but individual companies are improving. You also have to
consider which field are good with high return on capital.
Information Technology
I
would try to avoid information technology in China, despite the fantastic
growth. There’s no tangible book value. Disruption is too quick. Talent can be
lured away.
Telecommunications
Important,
but only somewhat predictable.
Utilities
Utilities
are important and knowable, but regulations and growth are a factor.
Financials
I
would say insurance and banks are worth learning. Capital adequacy, combined
ratios, are all important. However, I would rather invest in financials in the
U.S in small firms with no derivatives in their books. It’s more transparent in
the U.S and property and casualty insurance still has good margins. While life
insurance is growing like a weed in China, same with banking, there’s too many
hidden things. So it is important, but not knowable in China.
Property & Construction
I would not touch
property companies or construction in China. A lot of companies look extremely
cheap and have extremely valuable properties, but the stock price never goes up
and value is never unlocked. Also, there are many ghost towns in China and
while office buildings is more sustainable than residential construction, a
believe property is a bubble propped up my regulators.
HealthCare
I
would not touch pharmaceuticals and biotechnology where clinical trials are
necessary. However, I will leave room for distributors, prosthetics, and different
health clinics in China. That is something I would research on. Not all
segments in health care is appealing to me.
Conglomerates
I
don’t like researching conglomerates and I don’t believe in synergies or
analysis on sum of parts, etc. I believe in focusing and if I asked you, “what
does company this company do?” You should be able to tell me what their staple
business is in simple terms.
Consumer Staples
Important
and knowable
Consumer
Discretionary
Important
and knowable
In
particular, for Asia, I wouldn’t look into real estate, conglomerates, or financial
companies, but I would look for sure things like automobile parts and component
suppliers, food and beverage, which includes water, soda, beer, airports, and
things which are sticky in subscription or consumption; where the consumer
comes back to the product over and over again.
Actually,
China would not be a focus until my fund grows to a substantial size in AUM.
The advantage of having a low AUM is the ability to buy at low prices relative
to future cash flows generated with clean balance sheets, i.e great quick
ratios, working capital to sales, etc.
Net-net
opportunities are no brainers, which help protect the downside. If you can find
net-net opportunities with a certain amount of growth and ROIC, and you know
that the management is not corrupt, then you should do fine long term. But you
may have to venture in to different South East Asian markets to find this and
you will have to know management well enough.
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