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China's overlooked stocks enter spotlight with MSCI debut

Liquor company Kweichow Moutai and state-owned industrials are seen as beneficiaries

The inclusion of A-shares will see 234 mainland-listed stocks, including distiller Kweichow Moutai, joining the MSCI China Index.

HONG KONG -- As domestically traded Chinese stocks join MSCI's widely tracked market indexes on June 1, more international funds are expected to flow into China's traditional industries, which over the years have been underweighted by foreign investors.

Industrial companies, large-cap financials and the booming consumer sector -- which includes major liquor manufacturers Kweichow Moutai and Wuliangye Yibin -- are among those cited by analysts as having the best growth potential, as investors are catching up with their investments in domestic-oriented companies that have a smaller presence in overseas markets.

State-owned heavy industrial companies that currently trade only on mainland exchanges are also expected to benefit. Those include China State Construction Engineering, one of the world's largest construction companies, which is involved in various projects under President Xi Jinping's Belt and Road Initiative, and China Yangtze Power, the operator of the Three Gorges Dam hydroelectric plant.

Karen Li, head of China equity research at JP Morgan, said at a press conference on Thursday that she expects MSCI's A-share inclusion to prompt institutional investors to increase their exposure to the less risky but underweighted sectors.

"Within the A-share universe, I think there are some very interesting sectors which are less present in [Hong Kong-listed] H-shares," Li said, pointing to such sectors as premium liquor, automation and home appliances. She said most companies in these sectors are only listed on mainland stock exchanges but that there is huge interest among foreign investors.

Kweichow Moutai and Wuliangye Yibin are the among top five A-share stocks purchased by investors since the stock connect system -- which now provides access to shares listed on the Shanghai and Shenzhen exchanges through the Hong Kong market -- was launched in 2014, according to data compiled by Wind, a Chinese financial information services company. Both companies produce the traditional Chinese spirit known as baijiu, which is little consumed outside China.

Historically, China's "new economy" companies -- such as Alibaba Group Holding, Tencent Holdings and Baidu -- have had a higher presence in the portfolios of growth-driven foreign investors. However, other foreign investors who place less emphasis on high growth are looking for greater exposure to other Chinese industries without taking on too much risk.

Mainland-listed large-cap financial institutions and industrial companies fall into that category. While some companies -- including Industrial & Commercial Bank of China and China Construction Bank -- are also listed on other overseas markets, they have been somewhat underinvested in A-share markets, which is dominated by retail investors. Those smaller investors tend to buy cheaper small- and medium-cap stocks.

However, institutional investors, particularly pension funds, are more interested in companies with large capitalizations and stable growth.

"More investors are paying attention to the traditional large-cap stocks," said Jason Lui, Asia-Pacific head of equity and derivatives strategy at BNP Paribas. As fund managers take into consideration MSCI's A-share stocks, retail investors are likely to follow suit.

The inclusion of A-shares in the MSCI indexes will see 234 large-cap stocks representing an aggregate weight of 0.39% in the MSCI Emerging Markets Index at a 2.5% partial inclusion factor starting on Friday. The percentage will rise to 0.78% in September, increasing the inclusion factor to 5%. The move is expected to bring in between $17 billion and $20 billion to China's onshore equity markets over the first year, according to major banks and brokerages.

Unlike the current MSCI China index, which is limited to Chinese companies trading on overseas exchanges and dominated by Chinese technology companies, the revised index will give traditional industries higher weighting to better reflect the reality of the world's second-largest economy, said Baer Pettit, president of MSCI, in Hong Kong on Thursday.

Consumer staples, industrials, materials, brokers and health care account for only 12% of the current MSCI China Index, when they collectively comprise 46% of shares trading on mainland China's markets, according to estimates from JP Morgan. The information technology sector, which represents 41% of the current index, accounts for just 8% on domestic markets.

Analysts say a bigger weighting is needed for the indexes to make a material impact.

Pettit offered few clues about MSCI's next move, but he hinted that it will most likely take "larger steps" toward increasing A-shares' weighting in its indexes, without giving a timetable.

He said the timing of the next move would depend on factors such as the evolvement of investors' appetite in investing in A-shares, as well as the improvement of the regulatory environment of China's financial markets.

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