DOW JONES INDEXES
S E P T E M B E R 2002
CHINA STOCK MARKET IN A GLOBAL PERSPECTIVE
Research Report by
Sheldon Gao, PhD.
Senior Director, Dow Jones
Indexes
609-520-4114
sheldon.gao@dowjones.com
Executive Summary
China’s stock market has experienced amazing growth since establishing its two
exchanges in 1990, although the growth has been uneven and irregular, and the
market remains in the early stages of its development. This report seeks to identify
the key characteristics of China’s market and how they combine to form the most
dynamic and intriguing developing market in the world.
The current structure of China’s market is one of its key obstacles to further development. There are very few stocks that would fit the definition of “blue-chip” trading on China’s mainland exchanges. Whereas most developed markets are dominated 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 holdings, 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
CONTENTS
Introduction
Abnormal Performance
Tremendous Volatility
Insulated Market
Substantial Government Ownership
Irregular Expansion
Influence of IPOs
Typical Emerging Market
Pyramid Structure
Unstable Core
Outperformance of Micro Stocks
Incredible Speculation
Manufacturing Orientation
Disappointing Earnings of Companies
Low Dividend Yield
Conclusions
6
7
8
8
9
10
11
11
13
13
14
15
15
Performance of Major Indexes Worldwide (1994—2001)
First Eight Years of the Dow Jones China Index
Ten Biggest Up and Down Days in the China Market
Crucial Role of the Ten Best Days in the China Market
Performance of China Indexes in Domestic and Overseas Markets
Volatility of Major Indexes Worldwide (1994—2001)
Bull and Bear Markets in China (1994—2001)
Bull and Bear Markets in the U.S. and China (1896—2001)
Annual Return of Major Indexes Worldwide
Correlation Between Major Indexes Worldwide
Tracking Error Between Major Indexes Worldwide
Float Ratios of Major Stock Markets Worldwide
Free-Float Ratios of the China Market (%)
CHARTS
AND
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TABLES
September 2002
China Stock Market in a Global Perspective
2
CHARTS
AND
TABLES
(CONTINUED)
DOW JONES INDEXES
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September, 2002
Float Ratio vs. Stock Return in China’s Market
Government Ownership in the U.S. and Japan
Stock Market Expansions in the U.S. and China
The Role of IPOs in the U.S. and China Stock Markets
IPO Change vs. Index Performance in China’s Market
Shareholder Statistics in the U.S. and Japan Stock Markets
Correlation Between Major China Indexes
Market Concentration Measured by % of Stocks
Market Concentration Measured by # of Stocks
Market Coverage of Dow Jones Country Titans Indexes
Market Coverage of China Stocks (January 31, 2002)
Comparison of Market Concentration in China and Rest of the World
Tracking Error Between Major China Indexes
Stock Number: Dow Jones Global Indexes and China Indexes
Turnover Rate of Blue-Chip Indexes in Market Value
Turnover of Blue-Chip Indexes in Number of Stocks
Benchmark vs. Blue-Chip Indexes in China
Performance Comparison of China Indexes (1994 – 2001)
Composite Index vs. Stock-Selected Index in a Global Market
Performance Comparison of Benchmark vs. Tradable Indexes
Turnover Comparison of Several Stock Exchanges
Comparison of Sector Representation
Sector Representation of China’s Stock Indexes
P/E of Blue-Chip Indexes in Several Major Markets
P/B of Blue-Chip Indexes in Several Major Markets
P/E and P/B of TOPIX in Japan
Ratio of Stock Market Capitalization Over GDP in China
Summary of Index Payout Percentage Over the Past Two Years
Payout Ratio and Dividend Yield of Some Blue-Chip Indexes
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
with amazing rapidity since the
establishment of its two exchanges
in 1990. However, that growth has
been extremely irregular and has
not followed traditional models of
stock-market development. In many
ways, it is still in the early stages
of development.
China’s stock market has experienced tremendous growth and development
in the ten years since the inceptions of the Shanghai Stock Exchange
(December 19, 1990) and the Shenzhen Stock Exchange (December 1, 1990).
The number of listed companies reached 1,160 at the end of 2001 — up from
only 10 companies in the early 1990s — with a total market capitalization of
525.6 billion USD. In addition, more than 65 million investment accounts are
on record as of the end of 2001.
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 regulatory 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
Dow Jones China Index outpaced
many of the world’s best-known
indexes. But much of that superior
performance is attributable to a
specific share class, specific days
and a specific year.
China’s stock market delivered impressive returns during the eight-year period from 1994 through 2001, as measured by the Dow Jones China Index1.
The index included 549 stocks as of January 31, 2002 (282 in Shanghai and
267 in Shenzhen). As shown in Table 1, it outpaced many of the world’s bestknown indexes, including Japan’s Nikkei 225, Hong Kong’s Hang Seng
Index, the Dow Jones STOXX 600 covering Europe, and the Dow Jones
World Emerging Markets Index that covers 11 major emerging markets
around the world. Of the market indexes considered for this study, the Dow
Jones China Index’s cumulative return of nearly 80% for the eight-year period is second only to the high-tech driven U.S. stock market, measured by the
Dow Jones Industrial Average (DJIA). Coincidentally, the Dow Jones China
Index’s annualized return of 7.61% almost matched the annualized growth
rate of China’s GDP. But none of this means that China’s stock-market performance can be used as any sort of economic barometer.
Table 1. Performance of Major Indexes Worldwide (1994—2001)
Hang
Seng
DJ World
Emerging
Markets
DJ China
-4.13%
-41.16%
79.82%
DJIA
STOXX
Nikkei
225
Cumulative Return
166.95%
68.74%
-39.47%
Annualized Return
13.06%
6.76%
-6.08%
-0.53%
-6.41%
7.61%
Volatility
15.80%
14.53%
20.80%
31.09%
27.92%
51.10%
0.83
0.46
–
–
–
0.15
Return/Risk
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
The performance of the Dow Jones China Index in the first two tumultuous
years of its calculated history was grim at best — the index fell more than
50% even while China’s economy experienced explosive GDP growth.
Excluding 1994’s performance causes the annualized return over the past
seven years to rise steeply from 7.6% to 16.8%. Eliminating 1995 as well, the
annualized return for the six years would jump to 23.3%.
The story behind this performance is unusual and intriguing. The China
stock market displays unique performance characteristics at three different
levels, suggesting that the historical outperformance of China’s market is concentrated on a particular year, on particular days and within a particular segment of the market. We have labeled these three trends the “1996 Oddity,”
the “Single-day Oddity” and the “Segment Oddity.”
1
The base date for the Dow Jones China Index Series was set at December 31, 1993. This date
roughly coincides with the availability of reliable data and adequate market supervision, qualities
that were lacking in the stock market’s early stages.
China Stock Market in a Global Perspective
6
DOW JONES INDEXES
September, 2002
Chart 1, below, tracks the performance of the Dow Jones China Index for the
past eight years. Each 50-point interval of the Dow Jones China Index seems
to constitute a threshold. After dropping 30% in the first three months of
1993 and more than 60% in the first eighteen months of its existence, the
index took almost two and one-half years to recover its losses and regain its
base value of 100. Thanks to a 125% surge in 1996, the index broke through
both the 100- and 150-point barriers. But while the index first passed the
200-point mark in mid 1997, it finally encountered resistance at 250 points
when three upward surges in 2000 failed to cross that particular milestone.
The index’s high close remains 249.80 on August 21, 2000. The market
downturn that began in July 2001 has driven the index back to its levels at
the end of 1996. Therefore, while China’s stock market experienced five
strong upward surges in eight years, as marked in Chart 1, the one in 1996
was in actuality the sole contributor. This phenomenon can be termed the
“1996 Oddity.”
Chart 1. First Eight Years of the Dow Jones China Index
300
5
250
4
3
200
150
2
1
100
50
/0
1
/0
1
12
/3
1
00
/0
0
6/
30
12
/3
1
/9
9
0/
6/
3
12
/3
1
98
/9
9
6/
30
7
98
12
/3
1/
6/
30
/
7
31
/9
12
/
6
30
/9
6/
/9
6
5
31
/9
12
/
6/
30
95
31
/9
12
/
/9
4
6/
30
/
/9
4
12
/3
1
6/
30
12
/3
1/
93
0
Individual trading sessions also play a similarly decisive role in the index’s
performance, as shown by the “Single-Day Oddity.” Table 2 lists the top ten
one-day percentage gains and losses in China’s stock market over the past
eight years. The two worst years, 1994 and 1995, contain nine of the ten
largest “up” days and five of the ten largest “down” days. This concentration might be due in part to the implementation of a 10% circuit breaker
since December 26, 1996. However, since the circuit breaker is applied to
individual stocks rather than a particular index as at the New York Stock
Exchange, its effectiveness in muting fluctuations in the entire market is still
fairly limited.
China Stock Market in a Global Perspective
7
DOW JONES INDEXES
September 2002
Table 2. Ten Biggest Up and Down Days in the China Market
Date
% Gain
Date
% Loss
1
08/01/94
34.20
05/23/95
-17.20
2
05/18/95
28.57
10/05/94
-12.27
3
08/03/94
19.18
08/09/94
-10.73
4
08/05/94
16.59
12/16/96
-9.95
5
08/10/94
16.44
12/17/96
-9.86
6
09/05/94
15.93
10/14/94
-9.36
7
05/19/95
11.37
12/18/97
-9.28
8
10/07/94
10.91
05/22/97
-8.97
9
04/26/96
10.24
09/29/94
-8.42
10
02/22/95
10.04
05/16/97
-8.28
Average
17.35
-10.43
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
Experts and academia strongly advocate long-term investment and buy-andhold strategies and often provide justification for their theories by showing
what might befall an investor who missed the ten best trading sessions
through inept market timing. China represents an extreme case due to the
frequency and magnitude of these exceptional trading sessions, as well as the
contrast between the best and worst. For example, as illustrated in Chart 2, if
an investor missed all the ten best days in Table 2, he would have suffered a
65% loss over the past eight-year period, even if he was in the market on all
other days including during the best year—1996. Therefore, these ten best
days determined much of the positive performance of the investor’s portfolio.
Chart 2. The Crucial Role of Ten Best Days in the China Market
250
DJ China Index
200
150
100
Missing 10 Best Days
50
China Stock Market in a Global Perspective
8
1
/0
1
12
/3
1
6/
30
/0
/3
1/
00
12
6/
30
/0
0
/9
9
12
/3
1/
99
6/
30
/9
8
1/
98
12
/3
6/
30
7
31
/9
7
12
/
/9
6
0/
9
6/
3
/9
6
12
/3
1
/9
5
6/
30
12
/3
1
0/
95
6/
3
31
/9
4
12
/
6/
30
/9
4
12
/3
1/
93
0
DOW JONES INDEXES
September, 2002
At the market level, deviations among the performances of China’s indexes
covering different segments and serving different investor groups also reflect
the unusual nature of China’s stock market. We call this “Segment Oddity.”
In addition to the aforementioned four A-share stock indexes, Dow Jones also
developed the Dow Jones China Offshore Index, which covers all shares of
Chinese companies with non-RMB denominations that are available to global
investors such as class B and H shares and red-chips traded in Hong Kong.
With a base value of 100 as of December 31, 1991, this index covers 80% of
the total universe and of each sector and had 59 components as of April 30,
2002.
As demonstrated in Chart 3, in contrast to the approximately 80% gain on the
Dow Jones China Index, the Dow Jones China Offshore Index fell 35% over
the same eight-year period, or 5.24% per year on the average. Worse still, the
30-stock China Free Trade Stock Index derived from the Morgan Stanley
Capital International (MSCI) China-Free Index tumbled more than 87% in
the same time period.
Chart 3. Performance of China Indexes in Domestic and Overseas Markets
250
DJ China Index
200
150
DJ China Offshore Index
100
50
MSCI China-Free Index
China’s stock market displayed
extreme volatility during the eight
years from 1994 through 2001: an
average of 51.10% for the Dow
Jones China Index versus 15.80%
for the Dow Jones Industrial
Average. Bear markets also
occurred much more frequently in
the Dow Jones China Index but
were of shorter duration than those
registered by the DJIA.
1
1
12
/1
/0
00
6/
1/
0
1/
12
/
/0
0
6/
1
99
/1
/
12
1/
99
6/
/1
/9
8
12
7
98
6/
1/
/9
12
/1
1/
97
6/
/9
6
1/
96
12
/1
6/
/1
/9
5
12
4
1/
95
6/
12
/1
/9
6/
1/
94
12
/1
/
93
0
2. Tremendous Volatility
It is a generally accepted premise in the investment world that higher return
is accompanied by higher volatility. The efficient-frontier curve, which
reflects this intrinsic relationship, is also the foundation for modern investment portfolio theory. These rules hold true in China, despite the unique
nature of its stock market.
As shown below in Table 3, along with fairly impressive returns over the past
eight years, China’s stock market also demonstrates exceptionally high
China Stock Market in a Global Perspective
9
DOW JONES INDEXES
September 2002
volatility, as measured by the annualized standard deviation of the monthly
returns of the Dow Jones China Index. The index’s average volatility of
51.1% during the eight-year period is more than double—in some cases triple
—the figures for the developed-market indexes considered in this study. It is
also nearly double the number for the Dow Jones World Emerging Markets
Index. China’s market also demonstrates the top figures in terms of highest
and lowest volatility among the world markets examined in the comparison.
This high level of volatility is particularly unusual in a market like China,
where derivatives trading and short selling have never been permitted.
Table 3. Volatility of Major Indexes Worldwide (1994—2001)
DJIA
STOXX
Nikkei
225
Hang
Seng
DJ World
Emerging
Markets
DJ China
Average Volatility
15.80%
14.53%
20.80%
31.09%
27.92%
51.10%
Highest Volatility
20.90%
20.79%
25.13%
46.02%
45.14%
117.03%
(Year)
1998
2001
1995
1998
1998
1994
8.19%
5.24%
16.61%
15.99%
12.33%
17.34%
1995
1996
1999
1996
1996
2001
Lowest Volatility
(Year)
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
To put the Dow Jones China Index’s volatility in perspective, the DJIA’s
most volatile period in its 106-year history occurred during the Great
Depression with 50.7% volatility in 1933 and 45.7% in 1932. It has only occasionally risen above the 20% level since World War II and was even trending
lower in 1990s. The Nasdaq 100, long considered the most volatile major
index in the U.S., has never seen its volatility rise above 28% in its more than
17 years of existence.
It seems intuitive that an increase in the number of an index’s component
stocks would help reduce its volatility by enhancing the index’s diversification. However, at last count, the Dow Jones China Index had 549 stocks,
which is somewhat comparable with the 600 stocks in the Dow Jones
STOXX 600 and the 823 in the Dow Jones Emerging Markets Index.
Although the 30-stock DJIA, the 33-stock Hang Seng Index and the Nikkei
225 Index all have far fewer components, each of them had lower volatility
than the broad Dow Jones China index, as shown in Table 3. This suggests
that the high level of volatility of the Dow Jones China Index reflects actual
market movements rather than a flaw in its construction.
Another measurement of market volatility is to examine the frequency, magnitude and duration of market crashes. Although there are various methods
in the global financial arena for determining a bear market, the generally
China Stock Market in a Global Perspective
10
DOW JONES INDEXES
September, 2002
accepted standard is a 20% drop from a peak value. Table 4 lists all 12 bear
markets in China’s market since 1994. The falls range from 21% to 46%, with
an average drop of 34%. The longest bear market lasted for 426 days and the
shortest one for just 16 days, with an average duration of 4.5 months.
Table 4. Bull and Bear Markets in China (1994—2001)
Bull Markets
Bear Markets
Start
End
% Up
Days
Start
End
% Down
Days
1
01/22/02
03/21/02
33.8%
59
11/22/00
01/22/02
-41.2%
426
2
12/27/99
11/22/00
56.4%
324
06/29/99
12/27/99
-26.0%
180
3
05/18/99
06/29/99
71.9%
42
11/16/98
05/18/99
-21.1%
185
4
08/18/98
11/16/98
20.0%
90
06/01/98
08/18/98
-26.2%
78
5
09/23/97
06/01/98
35.3%
251
05/12/97
09/23/97
-35.1%
133
6
12/24/96
05/12/97
92.2%
140
12/09/96
12/24/96
-34.1%
16
7
01/22/96
12/09/96
242.0%
320
08/14/95
01/22/96
-29.6%
160
8
07/03/95
08/14/95
23.5%
42
05/22/95
07/03/95
-31.4%
42
9
05/10/95
05/22/95
54.6%
12
10/24/94
05/10/95
-29.5%
199
10
10/17/94
10/24/94
20.0%
7
09/06/94
10/17/94
-39.6%
42
11
07/29/94
09/06/94
167.0%
38
05/10/94
07/29/94
-44.1%
80
12
04/20/94
05/10/94
20.5%
20
01/10/94
04/20/94
-45.6%
101
69.8%
112
-33.6%
137
Average
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
In Table 5, the tremendous volatility of China’s stock market in comparison
with the DJIA can be viewed from four different perspectives: frequency,
magnitude, density and duration. The DJIA has experienced 32 bear markets
over the past 106 years but only ten since World War II—an average of once
every 5.5 years. But the Dow Jones China Index has gone through 12 bear
markets in eight years, averaging once every eight months.
Table 5. Bull and Bear Markets in the U.S. and China (1896—2001)
DJIA
DJ China
Index
History
Bull
Market
Average
% Gain
Average
Days
Bear
Market
Average
% Loss
Average
Days
106 years
8 years
30
12
108.6
69.7
915
112
32
12
-34.1
-33.6
343
137
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
The average magnitude of each bear market is comparable: a fall of 34.1% for
the DJIA and 33.6% for the Dow Jones China Index. However, the average
upswing for the two indexes after a bear market reaches its trough differs
China Stock Market in a Global Perspective
11
DOW JONES INDEXES
September 2002
significantly: a 108.6% rise for the DJIA but only a 69.7% rise for the Dow
Jones China Index.
During the Depression, the DJIA experienced two bear markets every year
in three consecutive years from 1931 through 1933—its densest concentration of bear-market occurrences ever. By contrast, as demonstrated in Table
4, China’s market witnessed a bear market three times in 1994, and two times
each in 1995, 1996 and 1999.
Finally, a bull market is much longer than a bear market in the U.S.—915 vs.
343 days, but a bull market is even shorter than a bear market in China—112
vs. 137 days. Put another way, while the average length of a bear market in
the U.S. is almost three times that of one in China—343 vs. 137 days—the
bull market in the U.S. is more than eight times longer that in China—915
vs. 112 days.
Volatility is generally a negative characteristic as far as financial investments
are concerned. It plays havoc with compound earnings, for one thing, but also
encourages a speculative mentality in investors who are led to make shortterm bets rather than long-term investments.
As a developing market, China’s economy is growing at a very fast pace,
allowing its stock market to deliver strong returns, despite its extreme volatility. The Dow Jones China Index rose 49% in 2000—the last time the DJIA
experienced such gains for a calendar year was 1933. And while the DJIA’s
record percentage increase for a calendar year is 81.7% in 1915, the Dow
Jones China Index far outstrips that figure with a 125% rise in 1996.
3. Insulated Market
The isolation of China’s stock
market can be attributed to the
government’s currency shield and
the existence of separate share
classes for foreign and domestic
investors. In comparison with other
markets, China displays low correlation and high tracking error.
In China, class A shares—the shares restricted to domestic investors—are
listed on either the Shanghai or Shenzhen exchanges and are denominated in
Renminbi (RMB), which are not freely convertible to any international currencies. Chinese investors cannot buy shares listed in Hong Kong and overseas, and foreign investors are not allowed to trade class A shares. The class B
shares that were created specifically for foreign investors have been available
to local Chinese investors since Spring 2001, but their market hardly compares with that of the A shares. The number of class B shares, 112, is less
than 10% the number of A-shares (1,160), and the B-share market’s total market value is only 2.4% of the A-share market’s value. The long-term performance of the B-share market also lags far behind that of the A-share market.
Market segregation and the currency shield helped China to protect its economy and markets during the Asian economic crisis of 1997 and the global
financial turmoil of 1998, but they remain a barrier between China’s capital
markets and international investors. The astonishing degree of this insulation
is revealed in an index-performance comparison.
China Stock Market in a Global Perspective
12
DOW JONES INDEXES
September, 2002
For example, fluctuations in the regional and global markets never impact
China’s A-share market. As shown in Table 6, China’s market soared by 38%
during the Asian financial crisis in 1997; and in 1995, when the global market
was being driven higher by low interest rates worldwide, China’s market tumbled another 15.6% following a plummet of 39% in the previous year. More
recently, in 2000, the market surged forward with a 49% gain even as global
markets faltered under the collapse of the Internet bubble.
Table 6. Annual Return of Major Indexes Worldwide (%)
Hang
Seng
DJ World
Emerging
Market
DJ China
DJIA
STOXX
Nikkei
225
2001
-7.1
-21.6
-23.5
-24.5
2.9
-25.5
2000
-6.2
-10.4
-27.2
-11.0
-34.0
49.3
1999
25.2
15.0
36.8
68.8
63.4
15.9
1998
16.1
25.3
-9.3
-6.3
-28.2
-12.2
1997
22.6
19.4
-21.2
-20.3
-23.0
37.9
1996
26.0
19.5
-2.6
33.5
4.4
124.9
1995
33.5
16.3
0.7
23.0
-7.9
-15.6
1994
2.1
0.4
13.2
-31.1
-0.3
-39.4
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
The insulation of China’s market is also demonstrated by the correlation
between China and the world’s major developed markets. As shown in Table
7, the correlation coefficient, ranging from +1 to –1, measures the relationship
between the movements of two indexes. For instance, the Japanese market
has a relatively low correlation across the board, suggesting it does not influence and is not influenced by other markets, even though it is the world’s
second-largest stock market. China, however, represents a far more extreme
example. Of the four major developed markets used in the comparison in
Table 7, none displayed a correlation coefficient with China higher than 0.05.
Table 7. Correlation Between Major Indexes Worldwide
DJIA
STOXX
Nikkei 225
STOXX
0.6791
Nikkei 225
0.4628
0.3946
Hang Seng
0.6760
0.5800
0.3238
DJ China
0.0332
-0.0351
0.0488
Hang Seng
0.0323
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
Tracking error, another statistical figure, also highlights the insulation of
China’s stock market. It measures the relationship between two indexes
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September 2002
based on the magnitude of their movements. Typically, any figure above 2%
suggests a significant deviation between the two.
A clear pattern in Table 8 can be easily identified. In general, the Law of
Universal Gravitation works in global markets just as it does in physics—the
bigger a market in size, the greater its influence on the movements of other
markets and the lower the tracking error between them. While China’s market follows this law, it demonstrates extremely high tracking errors with the
other indexes, providing further evidence of its extreme insulation.
Table 8. Tracking Error Between Major Indexes Worldwide
DJIA
STOXX
Nikkei 225
STOXX
3.52%
Nikkei 225
5.59%
5.78%
Hang Seng
6.76%
7.34%
8.99%
15.29%
15.48%
15.65%
DJ China
Hang Seng
17.02%
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
4. Substantial Government Ownership
Due to widespread government
ownership, China has a very low
float ratio, averaging just under
30% from 1993 through 2001.
Every stock market in the world has non-tradable shares, such as cross-holdings, government-owned shares and private holdings. To accurately represent
a stock’s liquidity and investability, an index must account for free float— the
proportion of freely tradable shares available to investors. With the growth of
index-based investment at the global level in which traditional benchmark
indexes serve as portfolio models, all four leading global index providers
switched or began the switch from full market value calculation to floatadjusted methodologies in the late 1990s.
The Dow Jones World Index, part of the Dow Jones Global Indexes (DJGI)
benchmark family, covers 34 stock markets in the world, including 23 developed markets and 11 emerging markets. Europe and the emerging markets
are both represented as unified regional markets. Designed to consistently
account for 95% of the free-float shares in each market, the index family’s
methodology further separates each total market index into three size segments—large, mid and small.
As of December 31, 2001, the Dow Jones World Index included 4,865 stocks
with a total market cap of over $23 trillion and a float-adjusted market value
of nearly $20 trillion. The average free-float ratio was 86.2%—86.4% for
developed markets and 77.5% for emerging markets. As illustrated in Table
9, among seven developed markets, the U.S. has the highest free-float ratio at
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September, 2002
93.9%, while Hong Kong has the lowest at 48.5%. The U.K., if examined
separately from Europe, has the highest ratio of any local market in the DJGI
family at 95.1%.
Table 9. Float Ratios of Major Stock Markets Worldwide
Singapore
Emerging
Markets
133
90
823
0.8
0.3
3.8
48.5
51.0
77.5
U.S.
Europe
Japan
Canada
Australia
HK
No. of Stocks
1,676
1,167
704
203
148
Global Weight
57.4
25.7
8.4
2.1
1.6
Float Ratio
93.9
79.7
79.6
82.0
87.8
Source: Dow Jones Indexes. As of January 31, 2002.
In contrast, the float ratio in China’s market is extremely low due to widespread government ownership. As an existing state-owned enterprise converts to a listed corporation, only one-third of its shares are typically issued to
the public. The rest remain in the hands of either the government or the
business itself and are not allowed to trade. Table
Table 10. Free-Float Ratios
10 shows an average float ratio of close to 30% for
of the China Market (%)
the 9-year period covering 1993 through 2001.
Because of the market’s extremely restricted
Year
Float Ratio
float, the Dow Jones China index series has been
2001
33.2
calculated with a float-adjusted methodology
2000
33.5
since its inception, unlike the composite indexes
1999
31.0
compiled by local exchanges.
1998
29.5
1997
29.7
1996
29.1
1995
27.0
1994
26.3
1993
24.4
Average
29.3
Source: China Statistical Yearbook;
Quarterly Report, People’s Bank of
China.
Generally speaking, stock markets in Asia such as
Hong Kong and Singapore tend to have relatively
low free-float ratios—probably because of cultural and historical reasons—but have never
dropped to the levels that are standard in China.
On the other hand, although more than twothirds of outstanding shares are not tradable in
China at this time, the steady increase in the
float ratio from 24% in 1993 to 33% in 2001
reflects a healthy trend.
Does the impressive performance of China’s market come from its abnormally low free-float ratio? Or it would perform even better with a high float ratio?
So far there is no clear evidence to support any suppositions in this regard.
When the index calculation method is changed to free-float adjusted from
full market cap, the weight of the stocks in the index shifts from low to high
float-ratio stocks. Without the evidence on a global basis, it is hard to determine if this would help or hurt index performance. As shown in Table 11, the
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September 2002
stocks with the highest and lowest float ratios outperformed all other three
groups in the middle in 2001, indicating that China’s market performance was
not related to its low float ratio.
Table 11. Float Ratio vs. Stock Return in China’s Market
Free-Float Ratio (%)
0-20
20-40
40-60
60-80
80-100
Average
Average Return (%)
-26.0
-27.5
-28.1
-29.3
-26.5
-27.77
Source: Dow Jones Indexes. As of January 31, 2002.
Government ownership of public companies around the world is shrinking,
and in the U.S. and Japan, the world’s two largest markets, it is severely limited. As summarized in Table 12, government holdings in Japan in 1996 represented 0.3% of the stock market, falling to 0.12% in 2000. In the U.S., the
number peaks at 0.83% in 2000, but many of these holdings are owned by
state or municipal governments instead of federal governments. Moreover,
the majority of government holdings in the world is concentrated in such sectors as telecommunications and utilities. Companies such as NTT in Japan
and Deutsche Telekom in Germany sometimes have as much as 40% of their
market capitalization controlled by the government.
Table 12. Government Ownership in the U.S. and Japan (%)
U.S.
Japan
Year
2000
1999
1998
1997
1996
2000
1999
1998
1997
1996
Ownership
0.83
0.66
0.59
0.65
0.59
0.12
0.21
0.22
0.21
0.30
Source: Statistics Report, Federal Reserve; Yearbook of Tokyo Stock Exchange.
But in China, the depth and breadth of government ownership of publicly
traded companies is truly unique. Based on data from Dow Jones Indexes,
the average government ownership in China’s stocks was 45%, as of January
31, 2002, with a maximum of 89%. Of 1,131 class A shares, only 117 on the
Shanghai exchange and 130 on the Shenzhen exchange could be considered
free of government ownership. This indicates that the government has ownership interests in 884 remaining stocks, or more than 78% of the total issues.
This “overhang” of unlisted shares means that shareholders have very little
control of the companies in which they invest.
Such a high percentage of government ownership does not exist anywhere
else in the world. It is a serious obstacle to the healthy development of
China’s economy and stock market, but it is hard to find an easy solution to
this historical issue. A plan implemented to reduce government ownership in
July 2001 triggered a 45% market crash and was ultimately abandoned on
June 24, 2002.
China Stock Market in a Global Perspective
16
DOW JONES INDEXES
September, 2002
Like all other economic phenomena, the valuation of a stock market is
dependent on the equilibrium of supply and demand. A sudden boom in
supply—in this case, the availability of stocks for trading—inevitably leads to
a market drop if demand fails to increase accordingly. There is the possibility
that a shift from full market-cap weighting to float-adjusted weighting by an
index provider could cause a disturbance in the marketplace by flooding the
market with shares as investors shift their portfolios to reflect the indexes.
Faced with an explosion of available shares, any market would be at risk of a
collapse. For example, if all family-owned shares were put on the market in
Hong Kong, float shares would almost double, an effect the Hong Kong market would find hard to bear. A case in point is the Tracker Fund of Hong
Kong, the first exchange-traded fund (ETF) in the Asia Pacific. It was originally created as a vehicle for the Hong Kong government to unload the
shares it bought during the financial turmoil in 1998 to maintain market stability. Since its launch in November 1999, the Hong Kong market has always
dropped significantly before its quarterly issuance.
5. Irregular Expansion
While most stock markets grow
primarily through the appreciation
of stock values, China’s market
growth mainly has been the result
of new share issuances, or external
expansion.
There are only two modes for the growth of stock market size. One is the
issuance of new shares such as IPOs, secondary offerings and follow-up offerings, and the other is the appreciation of existing stocks. The former is considered external expansion, while the latter is viewed as internal growth.
While both are driving factors for the growth of any stock market, the rapid
growth of China’s market primarily has relied on external expansion. In most
cases worldwide, the opposite has been the true.
Every index has a divisor, which can be adjusted to filter out the impact from
component changes and corporate actions such as stock splits and spin-offs in
order to maintain the continuity and consistency of the index. With a divisor
in position, the performance of a benchmark index that covers a consistent
portion of a market—say 80%—can be used as an indicator of the market’s
internal growth; the growth difference between the index and the total value
of the stock market measures the market’s external expansion. Since IPOs
are not immediately included in stock indexes, their value would be included
in the value of the entire stock market but not in the value of the index.
However, external expansion does not necessarily mean that market itself has
expanded in size. Often the introduction of new IPOs just means more stocks
competing for the same amount of money, while a lot of mergers and acquisitions might cause the market’s size to contract even as more IPOs are issued.
Table 13 compares the internal growth and external expansion of the U.S.
and China markets during an eight-year period. The “Size Change” and
“Index Gain/Loss” represent the changes in the total market capitalization
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September 2002
and index prices for each year. To achieve complete market representation for
the U.S. market, the 30-stock DJIA that covers roughly 25% of the total market
at any given time has been replaced by the 6,800-stock Wilshire 5000 index.
The growth rate of the total market value in the U.S. during the eight-year
period averaged at 14.6% per year, of which 12.3% came from the appreciation of existing stocks, with only 2.3% resulting from new stock issuance
(IPOs) and foreign stock listing (ADRs). In other words, 84% of the market
growth in the U.S. was the result of internal growth while only 16% was contributed by the issuance of new stocks. China’s market presents an entirely
different scenario. While the total market value grew at an annual rate of
47.4%, three times faster than the U.S., only 16.9% was the result of internal
growth, compared with 30.5% from external expansion. Therefore, almost
two-thirds of the market’s growth (64.4%) came from the issuance of new
stocks, making external expansion the principal driving force behind the market’s expansion. Not surprisingly, the market-growth pattern in China has
been labeled irregular.
Table 13. Stock Market Expansions in the U.S. and China (%)
U.S.
China
Year
Size Change
Index G/L
Difference
Size Change
Index G/L
Difference
2001
-11.1
-12.1
1.0
-9.5
-25.5
16.0
2000
-9.9
-11.8
1.9
81.7
49.3
32.4
1999
23.8
22.0
1.8
35.7
15.9
19.8
1998
23.0
21.7
1.3
11.3
-12.2
23.5
1997
33.3
29.2
4.1
78.1
37.9
40.2
1996
23.7
18.8
4.9
183.3
124.9
58.4
1995
35.3
33.4
1.9
-5.9
-15.6
9.7
1994
-1.3
-2.5
1.2
4.5
-39.4
43.9
Average
14.6
12.3
2.3
47.4
16.9
30.5
35.6%
64.4%
Percentage
84.3%
15.7%
Source: Dow Jones Indexes; China Statistical Yearbook; Quarterly Reports, People’s Bank of China.
Obviously, when a stock market mainly relies on external expansion, the relationship between changes in market size and the return on existing stocks
becomes weaker, and the return on existing stocks may fall far behind any
increases in market size. The growth of entire market no longer objectively
reflects the real investment performance of the majority of shareholders,
because they are unable to benefit from an external-expansion-driven
scheme unless they are consistently able to participate in one-day-profit
IPOs. When investors talk about the fast growth of China’s market, they may
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September, 2002
be focusing on the change of its total market value but ignoring the means by
which it has grown. In reality, extreme external expansion distorts perceptions of a marketplace because it has little relation to the actual investment
returns of long-term shareholders.
6. Influence of IPOs
IPOs represent a larger proportion
of the market capitalization of
China’s stock market than in other
world markets. The direction of the
stock market in any given year
seems to be closely linked to
whether the number of IPOs in that
year has increased or decreased
from the previous year. An increase
in IPOs is accompanied by a rise in
the index and vice versa.
For a market primarily driven by external expansion, steady growth depends
upon the non-stop stream of new listings, including IPOs and follow-up offerings. China’s stock market is a prime example of this. Table 14 compares the
role of IPOs in the U.S. and China. Over the 11-year period from 1991 to
2001, there was an average of 508 new IPOs in the U.S. each year with a total
average market value of 42 billion dollars. By way of contrast, China averaged
105 issues each year with a total market value of 70.3 billion RMB (about 8.5
billion dollars). It is not surprising that the U.S. market easily surpassed
China’s market with regard to the number of IPOs and the total market value
amount. The key factor in this comparison is the discrepancy between how
much of each market these new issues represent.
Table 14. The Role of IPOs in the U.S. and China Stock Markets
U.S.
Year
Number
of IPO
2001
85
36.3
2000
437
1999
1998
China
Total IPO
Total
(Bil.)
Market (Tril.)
Percent of
IPO (%)
Number
of IPO
Total IPO
(Bil.)
Total
Percent of
Market (Tril.) IPO (%)
13.8
0.26
72
116.8
4,352.2
2.68
80.5
15.5
0.52
141
210.2
4,809.1
4.37
541
72.8
17.2
0.42
96
94.5
2,647.1
3.57
381
39.6
13.9
0.28
106
84.2
1,950.6
4.31
1997
592
47.2
11.3
0.42
215
129.4
1,752.9
7.38
1996
864
56.1
8.5
0.66
207
42.5
984.2
4.32
1995
575
34.8
6.9
0.51
32
15.0
347.4
4.33
1994
570
22.7
5.1
0.45
108
32.7
369.1
8.85
1993
664
33.8
5.1
0.66
130
37.6
353.1
10.63
1992
512
23.4
4.5
0.52
39
9.4
104.8
8.98
1991
365
16.3
4.1
0.40
6
0.5
10.9
4.58
Average
508
42.1
9.6
0.46
105
70.3
1,607.4
5.82
Source: Dow Jones Indexes; China Statistical Yearbook; Thomson Financial; Dealogic.
In the U.S., new issuance accounts for less than 0.5% of the total market capitalization, but in China new listings represent close to 6% of the full market
value and 20% of the available float. In the more developed U.S. market,
IPOs are typically much smaller in comparison with well-established blue-
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September 2002
chip companies. However, in the still-developing China market, companies
launching IPOs can be significantly larger than many that have been trading
for some time. This is partly due to the fact that currently China’s market
lacks a stable core of blue-chip companies.
The number of IPOs not only determines the growth rate of the stock market, but also seems to be closely related to the direction of the market’s
movement in China. Table 15 depicts an odd and puzzling phenomenon:
whenever the total IPO amount increased from the previous year, the market
would rise; whenever it decreased, the market would fall. It would be simple
to dismiss this as coincidence, but the fact that the phenomenon repeated
itself for eight consecutive years without exception indicates otherwise.
Table 15. IPO Change vs. Index Performance in China’s Market
Year
IPO (RMB-Bil.)
IPO Change
China Index
Index G/L
2001
116.81
-44.5%
179.82
-25.5%
2000
210.30
122.5%
241.34
49.3%
1999
94.52
12.5%
161.65
15.9%
1998
84.01
-35.1%
139.45
-12.2%
1997
129.38
204.4%
158.81
37.9%
1996
42.51
182.8%
115.17
124.9%
1995
15.03
-54.0%
51.20
-15.6%
1994
32.68
-13.0%
60.64
-39.4%
1993
37.55
100.00
Source: Dow Jones Indexes; China Statistical Yearbook; Quarterly Reports,
People’s Bank of China.
It seems that the issuance of new stocks plays a key role in China’s stock
market. The market’s movement reflects neither China’s economic growth
nor changes in international markets. Instead, the direction of China’s stock
market seems to be determined by the increase or decrease in the number of
new listings.
The question remains as to whether the number of IPOs is a reflection of
market conditions or a driving factor. On one hand, the issuance of new
shares could dilute the concentration of money invested in other shares as
investors move their investments around, thereby causing a drop of existing
stock prices. In this sense, the increase of IPOs could be a main reason for a
stock-market fall, while the suspension of new listings could help stabilize
the market or even drive it up.
But on the other hand, a run-up in an IPO could also cause the prices of
China Stock Market in a Global Perspective
20
DOW JONES INDEXES
September, 2002
other related stocks to be pulled along as well, because price rallies in IPOs
are usually not limited to the first trading session but can last for several
weeks or even months. In the case of a very large IPO that gains immediate
admission to the index, the adjustment of the divisor on the first trading day
can certainly filter out its impact on the index, but continuous price increases
during the following days will inevitably push the index up. In addition, the
IPO effect may also have some positive impact on existing stock prices—a
rise in the tide lifts every boat in the sea. From this perspective, an increase
in the number of IPOs may help boost an index.
Whatever the answer, nowhere else is this correlation between the number of
IPOs and market movements so sharply defined. The effect of IPOs on
China’s stock market mainly depends on if IPOs effectively attract assets to
the stock market or if they are competing with existing stocks for limited
capital. In the case of the former, the stock market would be stimulated by
the new listings, but if the IPOs are competing for limited capital, the market
would suffer as a result. In truth, the reality probably lies somewhere
between these two extreme examples, but the question remains as to
whether the market is stimulated by new listings or whether the new listings
are the result of an invigorated stock market.
7. Typical Emerging Market
China is a typical emerging market
in many ways, including its large
number of small-cap stocks, its
large number of share classes, the
dominance of retail investors, its
two-exchange structure and the
strict regulation of IPOs by the
government.
Both of China’s exchanges are recent creations established in December
1990. There were no laws to govern corporations until 1994, and there were
no laws to regulate securities until 1999. Open-ended mutual funds were created as recently as 2000, and a draft of investment company law is not scheduled to be submitted to Congress until 2003. Not surprisingly, China demonstrates many of the features that are characteristic of emerging markets. They
are not only seen in the primary IPO market for public offerings but also in
the secondary stock-trading market. These features can be summarized into
five major points.
First, there is an overwhelming number of share classes to confuse investors.
Besides class A shares, which are restricted to domestic investors, and the B
shares trading in China for foreign investors, there are several additional
classes available to global investors and denominated in hard currencies.
The H, N, L and S shares are listed in Hong Kong, New York, London and
Singapore, respectively. If foreign-currency financing is the sole purpose,
ADRs or GDRs can be readily created, even if the RMB is non-convertible.
They are simpler and more flexible and effective in terms of raising capital in
hard currencies. Also, they put domestic and international investors on the
same platform, thus eliminating differences between them. The Deutsche
Bank and the United Bank of Switzerland (UBS) even created another brand-
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September 2002
new share class in 2001 by issuing “global shares” denominated in multiple
currencies.
Many of China’s blue-chip companies are listed only on overseas exchanges
and are not available to local investors. Although foreign listing is a commonly chosen option for companies in countries such as South Africa and Israel,
China’s implementation of this practice far outstrips that of any other country.
China Mobile, China Unicom, CNOOC, and Legend are all leading Chinese
companies as well as components of the Hang Seng Index. But while mainland Chinese are the customers, suppliers, producers and even employees of
these companies, they are unable to invest in them. As can be seen later, this
strange issue creates many structural drawbacks for China’s stock market.
Secondly, the Chinese government strictly regulates initial public offerings.
While regulations and government supervision are necessary for the successful and fair operation of any stock market, China represents an extreme case.
The government sets the quota for new listings each year, selects the qualified companies based on provincial and sector allocation, and — until 2001 —
even determined where the new stocks would list. China is the only country
in which the government completely controls the size of the stock market,
the pace of issue and the allocation of resources. Also, under current laws in
China, no company is allowed to list without three years of continuous profitability. As a result, only a few of the listed companies in China are young
and dynamic enterprises. This has led to the criticism that the stock market
favors state-owned companies over entrepreneurial ventures.
Another consequence of the overseas listing of China’s large companies is the
predominance of small-cap stocks, in both absolute size and in relation to the
rest of the world. The low free-float ratio in China makes the situation even
worse. For instance, the Dow Jones Emerging Market Index includes 12 markets—South Korea, Taiwan, Malaysia, Indonesia, the Philippines, Thailand,
South Africa, Mexico, Brazil, Chile, Colombia and Venezuela—and covers
95% of the combined market value. According to the parameters of this
index, the cutoff lines between large and mid-cap, and mid and small-cap
stocks are 1.2 billion and 210 million dollars respectively, as of December 31,
2001. Based upon this standard, only one company listed in China can be
classified as a large stock—Shenzhen Development Bank (Sinopec and
China Merchants Bank have big full but limited float market capitalization),
and 130 qualify as mid-cap stocks. The remaining 1,000-plus companies, or
88% of the total number, are small-cap or micro-cap companies.
The dominance of small stocks in China also can be measured by the average
trading price of all stocks. As of February 28, 2002, 326 stocks, or 9%, of the
3,3736 stocks trading on the Nasdaq stock market had a closing price under
China Stock Market in a Global Perspective
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DOW JONES INDEXES
September, 2002
$1, meeting the definition of a “junk stock.” At the same time, China’s market had a total of 521.8 billion shares outstanding with a full market value of
$525.6 billion dollars. This translates into an average price of $1.007 dollar
per share, compared with $34 and $23 at the NYSE and Nasdaq, respectively.
Another unusual feature of China’s stock market is the dominance of retail
investors. By contrast, in developed markets institutional investors tend to
dominate or at least represent a significant portion of the market. Table 16
summarizes the shareholder structure in the U.S. and Japan, where individual
investors account for no more than 40% of the market capitalization. In the
U.K., insurance companies also hold about one-third of the total market.
However, the holdings of institutions in China are estimated at less than 20%
of the market. Additionally, foreign investors, restricted to the B-share market, represent less than 2.5% of the A-share market’s total capitalization.
Foreign holdings for the U.S. and Japan represent 11% and 19% of each market, respectively.
Table 16. Shareholder Statistics in the U.S. and Japan Stock Markets
U.S.
Japan
2000
1999
1998
1997
1996
2000
1999
1998
1997
1996
Institutional
49.6
47.7
44.6
45.8
45.1
36.5
41.0
42.1
41.3
41.4
Individual
38.4
41.6
47.0
46.1
47.4
18.0
18.9
19.0
23.6
23.6
Foreign
11.2
10.0
7.8
7.4
6.9
18.6
14.1
13.4
9.8
9.4
0.8
0.7
0.6
0.7
0.6
26.9
26.0
25.5
25.3
25.6
Other
Source: Statistics Report, Federal Reserve; Yearbook of Tokyo Stock Exchange.
Finally, China’s stock market consists of two exchanges of similar size coexisting side-by-side. While many now-developed markets experienced a multiple-exchange period in their early stages, most have migrated to a singleexchange structure as smaller exchanges were driven out of business or
merged with the dominant exchange due to the introduction of electronic
platform trading. Australia had seven exchanges for more than 100 years until
1987, and Hong Kong had four exchanges from 1969 to 1986. Both markets
now have only one exchange each. Europe is an example of consolidation in
progress: alliances and partnerships between exchanges are constantly forming due to the creation of the Eurozone and euro currency. Based on these
examples, China’s market structure is definitely rare. The only similar case
today exists in India, where the National Stock Exchange and Bombay Stock
Exchange compete fiercely for investors and listings.
What is most unusual about China’s two-exchange system, however, is that
the stocks traded on the two exchanges perform quite differently. Though
China Stock Market in a Global Perspective
23
DOW JONES INDEXES
September 2002
the Shanghai Composite Index and Shenzhen Composite Index look to have
a similar trend, their correlation coefficient is as low as 0.82, close to the correlation between the Dow Jones Shanghai and Dow Jones Shenzhen indexes,
as shown in Table 17. Moreover, the difference in return has exceeded 5 percentage points for the past eight years.
Table 17. Correlation Between Major China Indexes
DJ China
DJ
China 88
DJ
Dj
Shanghai
Shanghai Shenzhen Composite
DJ China 88
0.9930
DJ Shanghai
0.9695
0.9590
DJ Shenzhen
0.9312
0.9294
0.8159
Shanghai Composite
0.9594
0.9444
0.9964
0.7973
Shenzhen Composite
0.9353
0.9227
0.8296
0.9873
0.8177
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
Although the correlation between the DJIA and the Nasdaq Composite from
February 1971 through November 1999 was just 0.75, the two indexes were
thought to represent the stocks of two different kinds of companies—Old
Economy and New Economy. But the two exchanges in China do not have
large differences in their sector representation, quotation systems and trading
schemes that the U.S. exchanges once had, making it that much harder to
explain the deviation between them.
A listing freeze on the Shenzhen exchange since January 12, 2001, has been
suggested as a possible reason. But in reality, the correlation between the two
exchange-calculated composite indexes has risen to 0.9846 from 0.8146 and
to 0.9755 from 0.8128 between the Dow Jones Shanghai and Dow Jones
Shenzhen indexes since the freeze.
8. Pyramid Structure
China’s stock market lacks truly
blue-chip stocks and so is
dominated by a large number of
smaller capitalization stocks, giving
it a pyramid structure. By contrast,
developed markets tend to be dominated by a small number of large
blue-chip stocks, giving them a
funnel-shaped structure.
Looking beyond the volatility and external growth of China’s stock market,
an observation of the structure of the market is more revealing. Because the
China market lacks real blue-chip stocks with high profitability, investors are
left to tinker in small-cap stocks for quick profits, which makes for a highly
speculative trading environment.
In each matured market, there is a group of blue-chip companies that acts as
the core or backbone of the market structure. These outstanding companies
usually share four key characteristics: large market value, low volatility, high
liquidity and a solid shareholder base. A developed stock market is generally
shaped like a top-heavy gyroscope or funnel—a few of these blue-chip companies may easily represent a huge chunk of the market or dominate the
China Stock Market in a Global Perspective
24
DOW JONES INDEXES
September, 2002
benchmark index’s movement. Meanwhile, the numerous small-cap companies at the bottom are relatively insignificant. A typical example is Nokia. A
single company represents roughly 73% of Finland’s total market value. In
Hong Kong, HSBC and China Mobile, combined, account for almost half of
the Hang Seng Index. But such is not the case in China. Without true bluechip companies in the A-share market, the market structure resembles a pyramid, and with the increasing number of listed companies, the aggregate market value accumulates slowly as more shares compete for a limited amount of
money.
Table 18 illustrates the top-down market concentration of several major markets in the world based on the DJGI family. In the U.S., the top 5% of the
total number of stocks in the benchmark total market index represented
58.4% of its market capitalization; this is close to the ratio for the global market—58.6%. While the distribution is far less top-heavy in markets such as
Japan, Australia and the emerging markets region, the top 5% of the total
number of stocks in each market still represents more than 40% of the broad
index. Before Nortel took its fall when the Internet bubble burst in 2000, the
top 5% of stocks represented 53% of Canada’s total market index. However,
in sharp contrast, the largest 5% of stocks in China represent only 18% of the
Dow Jones China Index; and the largest 33% of stocks account for 58.5%,
equivalent to the coverage of the top 5% of blue-chip stocks in the U.S. and
the world.
Table 18. Market Concentration Measured by % of Stocks (%)
% of Stocks
5%
10%
15%
20%
25%
# of Composite
U.S.
58.4
70.9
77.7
82.5
85.9
1,676
Japan
43.9
58.6
68.3
74.6
79.1
704
U.K.
57.3
69.4
76.6
82.0
85.8
328
Canada
36.2
52.7
63.0
71.3
76.8
203
Australia
42.2
60.8
69.5
76.7
81.2
148
Global
58.6
71.1
78.3
83.1
86.6
4,865
Emerging Market
44.7
58.6
67.2
73.7
78.6
823
China
18.1
28.9
36.4
43.1
51.8
549
Source: Dow Jones Indexes. As of January 31, 2002.
The contrast in market structure is even sharper when China is compared
with heavily concentrated markets. Table 19 lists those markets and provides
a comparison of the market coverage of the top stocks in their benchmark
indexes using data as of January 31, 2002. In Singapore—the least concentrated market after China in Table 19—the largest company, United Overseas
Bank, accounts for 16.5% of the free-float market value of the 90-stock
China Stock Market in a Global Perspective
25
DOW JONES INDEXES
September 2002
Singapore’s benchmark index. And the top 15 stocks represent 79% of the
index. But in China, the largest stock in terms of free-float market value—
Shenzhen Development Bank—represents less than 2% of the 549-stock
Dow Jones China Index.
Table 19. Market Concentration Measured by # of Stocks (%)
# of Stocks
1
3
5
10
15
# of Composite
Finland
73.1
84.7
88.2
92.9
95.3
30
Netherlands
24.6
43.3
57.6
79.2
87.7
61
Sweden
22.8
35.5
44.7
60.2
72.6
64
Switzerland
20.3
49.4
67.4
82.6
87.9
77
Singapore
16.5
42.8
56.8
70.8
79.1
90
Hong Kong
18.2
39.3
50.7
65.2
73.3
133
1.8
3.5
5.2
8.6
11.4
549
China
Source: Dow Jones Indexes. As of January 31, 2002.
The pyramid structure presents several unusual problems. First, no single
segment can be used as a proxy for the broader market with any accuracy.
The Dow Jones Country Titans Index series covers most of the developed
markets in the DJGI family. The Titans indexes are a series of tradable
indexes derived from the broad indexes of the countries they represent. As
shown in Table 20, the limited number of stocks—30, 50 or 100—of the
blue-chip indexes provides significant market coverage for each country, usually at least 60%. Therefore, a blue-chip index can generally and consistently
represent the whole market in these countries. However, China’s tradable
index, the Dow Jones China 88 Index, with the 88 largest and most liquid
stocks in China, represents only 24% of the broad market index’s capitalization. While these stocks are the blue chips of China’s market, they have little
in common with the generally accepted global standard.
Table 20. Market Coverage of Dow Jones Country Titans Indexes (%)
# of Stocks
Coverage
Global
Europe
Asia
Japan
UK
50
50
50
100
50
Canada Australia
40
30
30
HK
Singapore China 88
30
88
23.9
48.2
37.8
57.3
65.7
66.1
68.2
62.5
66.2
24.3
Source: Dow Jones Indexes. As of January 31, 2002.
Second, the pyramid structure forces index providers to add more components to the index to achieve appropriate market coverage. Table 21 breaks
down the number of stocks required to provide different levels of coverage
for China’s market. As can be seen, due to the pyramid structure it takes
China Stock Market in a Global Perspective
26
DOW JONES INDEXES
September, 2002
roughly 100, 200, 300, 400 and 500 stocks to achieve market coverage levels
of 30%, 40%, 50%, 60% and 70%, respectively. In other words, 513 stocks, or
45% of the total, are required to represent 70% of market capitalization. In
contrast, the U.S. market has just 186 stocks in its large-cap segment at the
same time according to the Dow Jones U.S. Total Market Index. Should
China’s stock market gradually grow to 3,000 or 5,000 stocks under its current
structure, how many stocks will be needed to represent the top 70% of the
market?
Table 21. Market Coverage of China Stocks (January 31, 2002)
Market Coverage
10
20
30
40
50
60
70
80
90
100
# of Stocks
21
61
119
192
282
387
513
664
851
1,131
% of Stocks
1.9
5.4
10.5
17.0
24.9
34.2
45.4
58.7
75.2
100
Source: Dow Jones Indexes. As of January 31, 2002.
Table 18 above illustrates that the largest 15% of stocks in a developed market often represent about 70% of the broad markets, the worldwide standard
definition Dow Jones uses to classify the large-cap segment. However the
percentage of stocks needed to represent approximately 70% of the broad
market index is three times higher for China. This unique market structure is
also vividly depicted below in Chart 4.
Chart 4. Comparison of Market Concentration in China and Rest of the World
100
90
Market Coverage
80
Global
70
60
Emerging Market
50
40
30
20
China
10
0
0%
5%
10%
15%
20%
25%
% of Stock Number
Third, the defects of the pyramid structure make it difficult to introduce
index products in China because of the inevitable disparities between the
benchmark index and any tradable index derived form it. A pyramid structure
China Stock Market in a Global Perspective
27
DOW JONES INDEXES
September 2002
increases the likelihood that these indexes will diverge from each other significantly because the blue-chip stocks that generally dictate the direction of
these indexes are simply not present.
Divergence between these two types of indexes can be measured by the
tracking error between them. Generally, tracking error below 1% indicates a
close relationship between two data series while anything above 2% suggests
a significant gap. Table 22 shows that the tracking error between any two of
the indexes considered is far above 1% and actually hovers around 10% in
some cases. Such gaps in performance are major obstacles to the development of index-based investment vehicles in China, particularly index futures
and other derivatives — tools that are vital for hedging, arbitrage and risk
management.
Table 22. Tracking Error Between Major China Indexes
DJ China
DJ China 88
DJ
China 88
DJ
DJ
Shanghai
Shanghai Shenzhen Composite
1.76%
DJ Shanghai
4.72%
5.38%
DJ Shenzhen
5.22%
5.19%
9.88%
Shanghai Composite
5.32%
6.10%
1.55%
10.38%
Shenzhen Composite
5.11%
5.51%
9.6%
2.23%
9.90%
Source: Dow Jones Indexes. From December 31, 1993 to December 31, 2001.
Additionally, the pyramid structure of China’s market makes it impossible to
create size-based subindexes using a globally consistent methodology. Style
indexes are an even more distant concept. Forcing the issue by applying a
size methodology designed for a different type of market structure would
only create artificial groupings and performance data completely lacking in
statistical significance.
The DJGI family methodology divides each of its covered markets into large-,
mid- and small-cap segments. The stocks in each market are ranked by floatadjusted market cap in descending order. Stocks falling within the top 70% of
the index’s market capitalization are classified as large cap; the next 20% are
considered the mid-cap segment. The remaining 10% are considered the
small-cap segment, but only the most liquid and largest companies representing half of the segment’s market capitalization are included in the index.
An obvious pattern can be seen for the eight markets shown in Table 23.
While the large-cap segment accounts for 70% of the total market, in each
case the number of stocks is less than that of the combined mid-cap and
small-cap segments. Likewise, the mid-cap segment, representing only 20%
of the market value, usually has fewer stocks (with Japan and Emerging
China Stock Market in a Global Perspective
28
DOW JONES INDEXES
September, 2002
Market as the only exceptions) than the small-cap segment which represents
5% of the total market capitalization.
Table 23. Stock Number: Dow Jones Global Indexes and China Indexes
Emerging
Singapore Markets
Size
U.S.
Europe
Japan
Canada
Australia
HK
Large
186
153
146
45
29
16
11
200
China
513
Mid
524
400
321
73
58
52
39
332
339
Small
966
614
237
85
61
65
40
291
114
Total
1,676
1,167
704
203
148
133
90
823
966
Source: Dow Jones Indexes. As of January 31, 2002.
These are generally accepted patterns that are followed by most markets
with the glaring exception of China. As demonstrated in Table 23, to represent just the top 70% of the Dow Jones China Index requires more than 500
stocks, or 45% of the total. Moreover, contrary to generally accepted norms,
China’s large-cap segment has the largest number of stocks—even more than
the mid-cap and small-cap stocks combined. This disparity can be explained
by the short history of China’s market economy and the fact that all of its
largest companies are listed on foreign exchanges but not on domestic ones.
Furthermore, if the index’s market coverage was expanded to 95% from the
current 80%, a total of 966 stocks would be needed to cover what Dow Jones
Indexes defines as total market representation—95%. The smallest stock
would have a capitalization of $59 million (500 million RMB), far below the
global average and standard.
Another drawback to the pyramid structure is the fact that it is not an effective shield against market manipulation. A normal top-heavy structure discourages market speculation because the large issues dominating the market
are too big to be manipulated and the small stocks have so little impact that
manipulation is not a big concern at the market level. But in a market with a
pyramid structure it is relatively easy to manipulate an index or even the
whole market by focusing on just a few stocks. This would jeopardize the
fairness and effectiveness of any index-based products, including futures and
ETFs.
The only obvious way to reduce the risk of manipulation is to add more component stocks to the index, but this course of action would lead to other
problems such as maintaining the liquidity and investability of the index.
China has several dozen truly liquid stocks, and adding many more constituent stocks would have an adverse effect on the index’s liquidity. As a
consequence, the pyramid structure makes it difficult to strike an appropriate
China Stock Market in a Global Perspective
29
DOW JONES INDEXES
September 2002
balance between market coverage and stock liquidity.
Finally, the pyramid structure also makes index-based investing particularly
difficult in China. With limited capital and assets under management, most
mutual funds and other institutional investors in China do not have enough
money or resources to hold the vast number of stocks required for index
replication over a long period of time. Accordingly, the creation of ETFs
remains a distant possibility as long as only a few financial institutions can
afford a large basket of stocks.
9. Unstable Core
China’s stock market lacks a
dominant core of blue-chip stocks.
This problem is closely linked to
high turnover in market indexes
and rampant market speculation.
These factors are serious obstacles
to the creation of viable indexbased products.
The “core-satellite” structure is another model that is typical of the world’s
stock markets. In this construct, the core of the index is composed of bluechip stocks with long histories of performance that seldom experience any
dramatic changes. The satellites are those companies sliding in and out of the
index because of insufficient size or liquidity and poor or unstable fundamentals.
This core-satellite scheme is a key factor contributing to the stability of an
index as measured by turnover rate. Table 24 shows the turnover rates of
Dow Jones Country Titans indexes over an 8-year period, calculated in terms
of market capitalization. The figure seldom reaches into the double digits,
and the average for each country ranges between 3.5% and 7% for developed
markets. This suggests that any displacement of component stocks involves
only smaller stocks that are not part of an index’s core. The same pattern
exists in the regional and global markets as well. The annual turnover rates of
the Dow Jones Global Titans 50, the Dow Jones STOXX 50 and the Dow
Jones Asian Titans 50 are never higher than 12%; and their average annual
turnovers are all below 8.5%.
Table 24. Turnover Rate of Blue-Chip Indexes in Market Value (%)
Year
Global
Europe
Asia
Japan
U.K.
Canada
Australia
HK
DJ China 88
2001
7.8
1.3
3.6
14.7
4.2
13.2
3.8
10.5
20.3
2000
11.3
9.8
11.4
12.1
8.6
7.9
3.6
5.9
17.8
1999
10.1
15.2
5.5
0.9
1.7
3.5
5.8
1.1
25.2
1998
10.8
6.3
1.9
4.3
6.5
2.0
15.3
8.5
38.8
1997
11.6
7.8
3.7
3.9
3.4
3.9
3.8
5.9
50.9
1996
6.3
11.8
4.6
4.9
0.0
7.6
6.7
9.2
64.5
1995
3.1
5.3
0.6
2.7
2.2
3.2
1.8
5.6
34.0
1994
5.4
6.2
3.2
0.0
1.6
1.2
1.4
9.2
19.8
Average
8.3
8.0
4.3
5.5
3.5
5.3
5.3
7.0
33.9
Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.
China Stock Market in a Global Perspective
30
DOW JONES INDEXES
September, 2002
However, this pattern does not manifest in China because there is no bluechip core—unless it is a highly unstable one—that can provide a focus point
for medium and small stocks. As shown in Table 24, the average annual
turnover rate in China during this eight-year period was nearly 34% with a
low of 17.8% in 2000. That low is still higher than the highest turnover level
for any of the other markets used in the comparison. This high turnover cannot be explained by the replacement of small-cap satellite stocks but rather
must involve the replacement of what would normally be considered core
stocks if China had a standard market structure.
But what is more surprising is the index turnover rate that is calculated based
on the number of constituents being replaced. Using the same eight markets
as before, Table 25 shows an average turnover rate of 56.5% for the Dow
Jones China 88 Index, at least four times higher than the highest figure of
13.1% in developed markets. Especially in 1996 and 1997, the turnover rate
reached a three-digit level for two consecutive years, indicating that the
entire component list was replaced in the course of one year, or all the constituent stocks were thoroughly shuffled at least once within a year.
Table 25. Turnover of Blue-Chip Indexes in Number of Stocks (%)
Year
Global
Europe
Asia
Japan
U.K.
Canada
Australia
HK
2001
8.0
4.0
6.0
32.0
12.0
35.0
6.7
20.0
35.2
2000
10.0
14.0
12.0
10.0
18.0
10.0
8.6
13.3
27.3
1999
14.0
18.0
12.0
1.0
4.0
10.0
8.6
6.7
36.4
1998
16.0
8.0
4.0
6.0
12.0
7.5
14.3
13.3
61.4
1997
20.0
9.0
4.0
8.0
6.0
12.5
8.6
23.3
105.7
1996
10.0
11.0
8.0
6.0
0.0
17.5
14.3
6.7
106.8
1995
6.0
8.0
2.0
4.0
4.0
10.0
8.6
13.3
48.9
1994
10.0
12.0
6.0
0.0
4.0
2.5
2.9
6.7
30.7
Average
11.8
10.5
6.8
8.4
7.5
13.1
9.0
12.9
56.5
50
50
50
100
50
40
30
30
88
# of Stocks
DJ China 88
Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.
These frequent shifts in constituent stocks have caused massive index
reshufflings—rare in international markets. The two types of turnover figures
can be interpreted as indicators of the stability of an index, and—by extension—the products based on it. If a low turnover rate based on market value
indicates the replacement of small-caps outside the index core, a low
turnover rate in terms of the number of stocks suggests the limited replacement of component stocks. However, both turnover rates have remained at
China Stock Market in a Global Perspective
31
DOW JONES INDEXES
September 2002
high levels in China, demonstrating that the index reviews involve the
replacement of a significant portion of the index and must include what
would normally be considered core stocks.
While it is not at all unusual for stocks to experience substantial rises or drops
in price due to management or financial issues, it extremely unusual for so
many stocks to go through such dramatic changes in such a short period of
time. The most likely explanation is the speculative nature of China’s stock
market.
An index with an unstable core is unsuitable as the basis for investment products. The lack of an index core has dragged heavily on the performance of
the Dow Jones China 88 Index in comparison with its benchmark, the Dow
Jones China Index. Table 26 shows that the Dow Jones China 88 Index
lagged the broad market significantly for all but two years. Its cumulative
return for the same period is less than half of that of the benchmark index.
Table 26. Benchmark vs. Blue-Chip Indexes in China (%)
Year
Returns
DJ China
DJ China 88
Volatility
DJ China
DJ China 88
2001
-25.49
-28.14
18.05
16.87
2000
49.30
33.40
20.64
23.07
1999
15.92
13.06
43.76
51.64
1998
-12.19
-23.09
21.61
19.64
1997
37.89
40.41
35.82
35.79
1996
124.92
129.18
48.87
46.42
1995
-15.56
-18.25
32.26
31.60
1994
-39.36
-40.10
117.03
110.08
79.8
31.4
51.1
50.0
Cumulative
Source: Dow Jones Indexes.
One likely explanation for the performance disparity is the “Tide Theory".
Speculation and manipulation activities drive a stock’s price up (flood tide)
until it becomes a component in the blue-chip index (high tide). But after
profits have been taken, the price of the stock falls (ebb tide) until it is
removed from the index in the coming review (low tide) and replaced by
another stock caught up in a flood tide. This leads to the outperformance of
non-core stocks in a flood tide over the core companies in an ebb tide. The
theory is given credence by the high turnover rates both in the number of
stocks and in market capitalization and by the significant performance differential between the blue-chip and benchmark indexes.
China Stock Market in a Global Perspective
32
DOW JONES INDEXES
September, 2002
China’s market also displays abnormal volatility patterns. In most markets,
more constituents mean lower volatility due to increased diversification. But
Table 26 shows that the broad index for China was more volatile than the
China 88 in six years out of eight, despite the fact that the broad index has
461 more stocks. Furthermore, the Dow Jones China Index and Dow Jones
China 88 Index display a high correlation of 0.9930 as shown in Table 17 in
spite of the discrepancy in their returns, indicating that while the two indexes
displayed similar price movements, the Dow Jones China Index consistently
beat the China 88 Index.
The underperformance of China’s tradable index makes it less desirable as
the basis for index-based products such as derivatives, particularly since in
most markets, money chases performance. In addition, high turnover in a
tradable index reduces the effectiveness of many of the usual advantages of
index-based investing by raising management fees and detracting from the
usual tax advantages.
10. Outperformance of Micro Stocks
While in most developed markets,
blue-chip stocks outperform
smaller capitalization stocks over
the long term, China’s micro-cap
segment apparently outperforms
what would normally be considered
its blue-chip segment.
The question of which market segment has displayed the best performance
is answered in Table 27. The Dow Jones China 88 Index, which includes the
largest and most liquid 88 stocks, had the most disappointing returns of the
six indexes used in the comparison. Its cumulative and annualized returns of
31.4% and 3.5% trailed those of the other indexes by significant margins. And
while the “blue-chip” index underperformed the 80%-coverage benchmark
Dow Jones Shanghai and Dow Jones Shenzhen indexes, those indexes in
turn underperformed the Shanghai and Shenzhen all-share composite indexes compiled by the local exchanges.
Table 27. Performance Comparison of China Indexes (1994 – 2001)
DJ China
DJ
China 88
DJ
Shanghai
DJ
Shenzhen
Shanghai Shenzhen
Composite Composite
Cumulative Return
79.8%
31.4%
92.8%
82.7%
102.0%
103.3%
Annualized Return
7.6%
3.5%
8.6%
7.8%
9.2%
9.3%
Volatility
51.1%
50.0%
60.8%
46.8%
61.3%
48.0%
Return/Risk
0.1489
0.0694
0.1407
0.1671
0.1500
0.1930
Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.
What is even more puzzling is that with the increasing number of stocks, the
volatility of indexes rises rather than falls with the improved diversification.
In particular, the volatility of the Shanghai Composite and Dow Jones
Shanghai benchmark indexes far exceeds that of the tradable Dow Jones
China 88 Index. Obviously, this runs counter to accepted norms and even
common sense.
China Stock Market in a Global Perspective
33
DOW JONES INDEXES
September 2002
However, it is important to consider for the sake of this comparison three
major differences between the Dow Jones indexes and those calculated by
the local exchanges. First, while the Dow Jones indexes include only A
shares, the composite indexes contain both A and B shares. Furthermore,
while the Dow Jones indexes are float-weighted, the exchange indexes use
full market cap in their calculation. Finally, the composite indexes include
every share traded on their respective exchanges, while the Dow Jones
Shanghai and Shenzhen indexes only cover the top 80% of the market.
The class B shares included in the composite indexes have trailed class A
shares significantly in performance and only represent about 2.5% of the size
of the A-share market with very slim trading volume. If they have any effect
on index performance, it is a negative one. As for index calculation, there is
no evidence that float-adjustment helps or hurts index performance.
Therefore, if neither of these two factors sufficiently explains the outperformance of the composite indexes, it must be the result of the differences in
the number of components.
This reasoning suggests that the best-performing segment of China’s market
is not the blue-chips represented in the Dow Jones China 88 or the large- and
mid-cap stocks embraced by the two Dow Jones benchmark indexes, but the
small- or micro-cap stocks that are excluded from the Dow Jones indexes2.
The higher volatility of small-cap and micro-cap stocks also helps to explain
why the Shanghai and Shenzhen Composite indexes show greater fluctuations than the Dow Jones indexes despite the larger number of stocks.
Table 28. Composite Index vs. Stock-Selected Index in a Global Market
Benchmark Index
December 31, 1983 – December 31, 2001
Wilshire 5000
Returns
521.2%
Volatility
15.6%
January 31, 1983 – December 31, 2001
Nasdaq Composite
Stock-Selected Index
DJIA
696.2%
15.7%
Nasdaq 100
Returns
685.3%
1166.6%
Volatility
23.9%
27.5%
August 31, 1988 – December 31, 2001
TSE 300
TSE 35
Returns
134.0%
205.9%
Volatility
15.3%
15.4%
Source: Dow Jones Indexes.
2
The small-cap stocks here refer to those with relatively low capitalization in the market, rather
than the small stocks mentioned earlier that are distinguished from large- and mid-cap stocks in
the statistical sense.
China Stock Market in a Global Perspective
34
DOW JONES INDEXES
September, 2002
There are stocks that most investors will not bother to look at in any stock
market. They are generally characterized by small capitalization, low credit
rankings, disappointing performance and poor liquidity, and therefore are
naturally excluded from all stock-selected indexes but still included in a composite index. As a result, it has become a universal pattern and principle that
indexes with parameters for inclusion have always outperformed composite or
quasi-composite indexes, as displayed in Table 28.
Furthermore, a tradable index also usually beats the benchmark index it is
based on over the long run as shown in Table 29. Benchmark indexes are typically dragged down by bottom-tier stocks that are usually filtered out by
more focused indexes. A notable exception is Canada where Nortel dominated the index for a time with its huge market capitalization before entering
into a spectacular decline. This general trend makes the performance patterns of China’s market a bit of a mystery.
Table 29. Performance Comparison of Benchmark vs. Tradable Indexes
Global
Europe
Asia
U.S.
Tradable
Returns
Japan
Canada Australia
HK
68.4
126.4
-1.1
191.4
-29.2
68.1
71.6
153.9
Volatility
15.1
14.9
22.7
14.4
23.7
20.2
18.9
30.8
No. of Stocks
50
50
50
30
100
40
30
30
Benchmark
Returns
61.2
79.2
-21.4
130.0
-32.0
75.9
60.1
84.5
Volatility
15.1
14.9
22.7
14.4
23.7
20.2
18.9
30.8
No. of Stocks
4766
1049
1653
1626
704
201
152
128
Source: Dow Jones Indexes. From December 31, 1993 through December 31, 2001.
Small-cap stocks sometimes outperform blue chips in a developed market for
a variety of reasons. The small base and low starting point of small-cap companies makes it fairly easy for them to achieve relatively rapid growth in sales
and profits, which eventually translates into a corresponding rise in stock
prices. By contrast, the “Law of Large Numbers” and the law of
“Diminishing Marginal Efficiency of Productivity” both contribute to the difficulty faced by large companies in achieving similar growth rates. Also, the
investment environment can contribute to small-cap outperformance — a
“flight to quality” can cause investors to shift their capital to blue-chips and
drive up the prices of those stocks, rendering the small-cap stocks more
attractive because of their more reasonable valuations. In addition, small-cap
stocks are more likely to be manipulated due to their relatively small sizes.
Speculation and manipulation activity may achieve tremendous short-term
gains as investors blindly follow the momentum. And finally, IPOs, which are
China Stock Market in a Global Perspective
35
DOW JONES INDEXES
September 2002
generally small-cap companies, typically deliver impressive returns after listing, because they are always priced with some room for increases. Such “IPO
Effects” may impact an index despite any divisor adjustments, because their
initial rise may continue for a number of days.
In developed stock markets, a small-cap rally usually is the result of high valuations in the large-cap segment and the fact that it is much easier for smallcap stocks to show high percentage increases for their prices. These small-cap
rallies usually do not last that long. For one thing, IPO effects and any
attempts at market manipulation are always small enough to be ignored
because of the dominance of blue-chip stocks in most markets. But in China,
the outperformance of its smallest stocks is driven mainly by speculation and
new IPOs. On one hand, statistically speaking, small-caps in China have neither a higher growth rate nor a significantly lower market valuation in P/E
ratio. On the other hand, the pyramid structure of the market indirectly
amplifies the influence of stock manipulation on an index. The limited size
differences among companies make stock prices easier to manipulate, and
that manipulation can easily affect the movement of the index. Meanwhile,
since IPOs are so much larger in proportion to the rest of China’s market than
in other markets, as analyzed before, they play a much more significant role
in composite indexes, and IPO effects may become a decisive element influencing the market movement to some extent.
11. Incredible Speculation
China’s stock market displays
extremely high turnover, with an
average holding period of about two
months from 1994 through 2001.
The figure is indicative of the
market’s rampant speculation.
The most commonly used indicator to measure the degree of speculation in a
market is the average stock turnover calculated as the total annual trading
value divided by the average market capitalization. A higher turnover points
to a higher frequency of trading, or a shorter holding period, which in turn
implies a greater level of speculation. A turnover of 100% suggests that the
average holding period for a single stock is one year. Statistics show that a
developed market usually has a lower turnover level than an emerging market, because long-term investing and buy-and-hold strategies are more
ingrained in the investing culture. Investors have more confidence in longterm economic development and the steady growth of corporate profits.
Table 30 compares the turnover in China with that of several developed markets on an annual basis from 1994 to 2001. The annual average for China over
the eight-year period was more than 500%, suggesting that an individual
stock changed hands five times a year on average, or the average holding
period is merely a little over two months. That is roughly ten times the average turnover of most developed markets. In a developed market, the normal
holding period for a single stock is about two years — even three years for
Canada and Singapore. However, China’s annual turnover fell steadily
throughout the eight-year period, reflecting a healthy trend.
China Stock Market in a Global Perspective
36
DOW JONES INDEXES
September, 2002
Table 30. Turnover Comparison of Several Stock Exchanges (%)
NYSE
Tokyo
Toronto
Australia
HK
Singapore
Taiwan
China
2001
87.9
61.3
56.7
65.5
50.2
34.3
159.6
264.8
2000
89.0
60.8
59.4
58.2
63.5
38.8
195.3
378.1
1999
72.7
50.7
41.8
47.1
40.5
33.8
237.6
381.3
1998
67.4
35.0
41.0
47.9
63.9
28.3
261.8
409.7
1997
59.6
34.5
33.4
50.6
118.3
28.8
368.5
590.4
1996
54.3
28.6
25.5
–
40.6
–
243.4
744.1
1995
50.8
23.1
18.9
–
34.3
–
199.6
430.3
1994
55.1
25.6
17.3
–
51.7
–
352.5
838.8
Average
67.1
40.0
36.7
53.8
57.9
32.8
252.3
504.7
Source: Yearbook of Stock Exchanges; China Statistical Yearbook; Quarterly Statistics,
People’s Bank of China.
Speculation is so widespread throughout China’s stock market that no one
group can take the blame. Individual investors, driven by the “herd mentality” to take profits where they can, are simply fighting for financial survival in
a cutthroat investing environment. Institutional investors frequently engage
in speculation, but the bizarre features of China’s stock market make the construction of a traditional portfolio all but impossible. The fundamental truth
is that the investing environment of China’s stock market simply does not
encourage long-term investment strategies.
Speculation can jeopardize the integrity of an index, particularly in the area
of constituent selection. For example, liquidity is a standard criterion used in
stock selection for almost any kind of index. In a market rife with manipulation, small stocks experiencing strong momentum and unusual liquidity
might be selected into the index, even though it would be for largely manufactured reasons. This danger may partly explain why such well-known and
long-established indexes as the DJIA, the S&P 500, the Hang Seng and the
Nikkei 225 have used a committee-based approach to component selection
since their inceptions. When they were created, the markets they represented were the developing markets of their day, and speculation and manipulation were very common.
It must be noted that speculation is not an entirely negative phenomenon—
it provides liquidity in a market and encourages trading activity. The QQQs
and SPDRs, the two largest and most traded ETFs in the world, had turnover
figures of 3250% and 1380% in 2001, respectively. But those are only two
trading products in the broad and diversified U.S. market, whereas China
represents a much more extreme example. The high level of liquidity in
China’s markets is accounted for in the construction of the Dow Jones China
China Stock Market in a Global Perspective
37
DOW JONES INDEXES
September 2002
index series, which uses three-month average prices rather than single-day
“snapshot” data.
The cycle of speculation pervades the movements of China’s stock market. A
few small-cap stocks are pushed higher through manipulation, but as they
turn into large caps and index consituents with a broad range of investors,
they are abandoned in profit-taking in favor of a new group of small-cap
stocks ripe for manipulation. This repetitive cycle’s long-term effect is to
boost the small-cap segment while running down the large-cap segment,
thwarting the development of an index “core” and the emergence of a bluechip segment. Given this, we can conclude that the pyramid structure of
China’s stock market is a leading cause of its instability, the dominance of
small-cap stocks and high levels of market speculation.
12. Manufacturing Orientation
China’s stock market has a high
concentration of industrial stocks,
according to the Dow Jones Global
Classification Standard—more than
24%. The allocation for the Dow
Jones World Index is just 11.2%.
China’s stock market leans heavily towards the industrial sector, with many
manufacturing-oriented operations. Based on the Dow Jones Global
Classification Standard, the Industrial sector, one of ten economic sectors,
represents 24% of the Dow Jones China Index, much more than the Dow
Jones World Index’s allocation of 11.2%. The Dow Jones Japan Total Market
Index comes the closest with an industrial sector that accounts for 20% of its
benchmark.
Other sectors with strong manufacturing ties also have significant representation in China’s stock market. As demonstrated in Table 31, the Industrial,
Basic Materials, Consumer Cyclical and Consumer Noncyclical sectors combined cover more than 70% of the broad index’s market capitalization. At the
Table 31. Comparison of Sector Representation (%)
U.S.
Basic Materials
Europe
Japan
Canada Australia
HK
Singapore Global China
2.2
4.3
5.6
12.6
15.3
0.6
0.4
3.5
17.8
13.5
12.0
26.9
7.0
18.7
5.4
12.4
13.9
18.9
Consumer, Noncyclical
7.6
8.6
5.4
3.1
5.5
1.9
3.4
7.5
8.5
Energy
5.6
10.2
0.6
14.6
2.2
2.6
0.0
6.4
3.4
Consumer, Cyclical
Financial
19.0
27.3
16.8
32.5
42.1
34.5
58.3
21.9
9.0
Healthcare
14.3
10.8
6.3
2.8
3.4
0.0
0.8
11.6
6.2
Industrial
11.7
7.2
20.3
11.3
7.5
19.2
11.5
11.2
24.2
Technology
18.1
6.9
9.4
9.1
0.2
3.6
5.6
14.0
6.8
Telecommunications
5.0
8.6
3.3
5.4
4.2
22.6
7.7
6.4
0.2
Utilities
3.0
4.1
5.4
1.6
0.9
9.7
0.0
3.6
5.0
Source: Dow Jones Indexes. As of January 31, 2002.
China Stock Market in a Global Perspective
38
DOW JONES INDEXES
September, 2002
global level, those same sectors only account for about 36% of the Dow Jones
World Index, so it’s not surprising that China has been nicknamed the
World’s Factory and the Global Manufacturer. By contrast, sectors representing a significant portion of the global market, such as Financial, Technology
and Healthcare, are severely reduced in China.
There are some other interesting features of the sector distribution of China’s
stock market that are the result of government policies. For example, China
Mobile and China Unicom are listed and traded in Hong Kong only; as a
result, Hong Kong is heavily over-weighted in telecommunications stocks at
22.6%, while China’s telecommunications sector represents about 0.2% of its
market. Likewise, CNOOC and Legend Holdings, the leading companies in
the energy and technology sectors are only listed in Hong Kong, skewing the
representation of the sectors in both markets. And none of the four leading
state-owned commercial banks are listed in China, creating a further distortion in the representation of its financial sector.
However, it must be noted that the sector representation in China’s market is
not unreasonable for a market with only a decade of history under its belt.
Developed markets may have severely skewed sector allocations too. In
Singapore, Australia, Hong Kong and Canada, the financial sectors account
for between one-third and one-half of the broad market indexes, while their
consumer noncyclical and healthcare sectors are extremely small.
Table 32. Sector Representation of China’s Stock Indexes
In Number of Stocks
In Market Value (%)
DJ
Shanghai
DJ
Shenzhen
DJ
China
DJ
China 88
DJ
Shanghai
DJ
Shenzhen
DJ
China
DJ
China 88
Basic Materials
42
61
103
13
14.1
21.5
17.8
14.6
Consumer, Cyclical
64
46
110
15
22.0
15.8
18.9
17.9
Consumer, Noncyclical
31
25
56
3
9.3
7.7
8.5
2.7
Energy
6
9
15
5
2.3
4.4
3.4
4.4
Financial
15
14
29
12
8.0
10.1
9.0
17.3
Healthcare
20
17
37
2
6.7
5.6
6.2
2.1
Industrial
79
68
147
19
26.3
22.2
24.2
20.3
Technology
13
14
27
12
6.6
7.1
6.8
12.8
1
1
2
0
0.2
0.2
0.2
0.0
11
12
23
7
4.7
5.4
5.0
7.9
282
267
549
88
100
100
100
100
Telecommunications
Utilities
Total
Source: Dow Jones Indexes. As of January 31, 2002.
China Stock Market in a Global Perspective
39
DOW JONES INDEXES
September 2002
Another aspect of the sector allocation of China’s market to be considered is
the differences between the broad and tradable indexes. As shown in Table
32, those differences are not terribly large, neither in terms of the number of
stocks nor the portion of market capitalization. The Dow Jones China Index
and China 88 have relatively similar sector allocations. The same cannot be
said for the rest of the world. For example, the top few banks in Canada,
Singapore and Australia are always among the largest companies in their markets and tend to dominate their respective indexes.
While there is no set standard for what the ideal sector allocation in a market
should be, a truly diversified market with balanced sector allocations may suffer less during the transitions between business and economic cycles. And as
the sector-based investment gains popularity, a balanced market may be more
attractive to investment portfolios.
13. Disappointing Earnings of Companies
The high P/E ratio of China’s
market, when considered in conjunction with its P/B ratio, indicates that the market is seriously
overvalued.
Views vary greatly on the size of the bubble in China’s stock market, but it is
indisputable that the low earnings posted by most companies are a prevailing
problem, which leads to high valuations. The price-to-earnings ratio (P/E) is
the simplest and most common way to measure a stock’s valuation, with trailing P/E based on the company’s real earnings for the previous 12-month period and projected P/E based on its expected earnings for the coming 12
months. Table 33 displays both statistics for the blue-chip indexes in China
and a range of other regions and developed markets. Since no international
securities analysts cover the class A share market so far, there is no projected
P/E available for the Dow Jones China 88 index.
Table 33. P/E of Blue-Chip Indexes in Several Major Markets
Global
Europe
Asia
Japan
Canada
Australia
HK
Singapore China 88
No. of Stocks
50
50
50
100
40
30
30
30
88
Trailing P/E
23.4
24.5
25.3
35.9
22.1
19.5
17.6
19.9
44.2
Projected P/E
21.9
21.6
22.4
27.4
17.9
16.3
15.2
21.9
–
Source: Dow Jones Indexes. As of January 31, 2002.
The trailing P/E for the China 88 at 44.2 is well above that of any of the
other indexes shown in Table 33. The fact that this figure represents the
index’s valuation after a 40% drop from its peak in June 2001 indicates that
the index’s P/E may have reached as high as 70 before the market crash.
Such a high P/E ratio is a red flag. The latest academic research has unveiled
a quantitative relationship between P/E and future stock return based on the
1949-2000 statistics of S&P 500 Index. The average annual rate of return in
China Stock Market in a Global Perspective
40
DOW JONES INDEXES
September, 2002
the stock market over the next five years according to Trevino and Robertson
is 20.67 minus the product of 0.57 and the trailing P/E.3 This means that the
higher the trailing P/E is, the lower the future return. Although the result is
obtained based on the data in the U.S. market over the past five decades, it is
meaningful to China’s market as a reference.
The relative P/E ratio is one of the most important indicators for global
investment. Some international investors periodically adjust their portfolios
in accordance with the economic conditions and market valuations in different countries. For instance, the trailing P/E was 63.2 for the S&P 500 Index
at the end of January 2002 and unavailable for the Nasdaq-100 Index due to
the negative earnings.4 This was one of the major reasons why many global
investors were retreating from the U.S. market. Japan was another market
they avoided because of overpricing and a pessimistic economic outlook.
This extreme valuation would normally indicate the possibility of a stockmarket bubble, but this is not necessarily the case. China’s stock market is
unique in its independence and isolation from international markets. The
non-convertible RMB acts as a high wall separating China from the rest of
the world’s markets. Since capital cannot move across the border, Chinese
investors have no alternatives—they are operating in a closed or insulated
market. Such encapsulation has resulted in a huge difference between the
P/E ratios of China’s companies listed in domestic and overseas markets.
Most of companies operating in China but listed elsewhere have normal
P/Es. For example, those for CNOOC, China Mobile, China Unicom and
Legend—all components of the Hang Seng Index—range between 11 and
29. China’s high stock prices will remain until competitors and challengers
come up.
The P/E ratio is by far the most widely used measurement for stock valuation, but it has its limitations. For instance, rather than being an isolated figure, the P/E ratio is subject to the influence of a number of factors, such as
economic cycles, interest rate levels, market sentiment, and investors’ expectations.
The P/E ratio is often related to the sector or industry classification of a company. Information technology and biotechnology stocks tend to have higher
P/E ratios than industrial and manufacturing companies because people are
willing to pay more for their future growth potential. This tendency makes
China’s market, with its heavy industrial slant, look all the more unusual for
its high valuation. It indicates that China’s manufacturing companies are far
behind the global standard in terms of profitability, probably because of low
efficiency or poor management, or both.
3
Trevino, Rubin & Fiona Robertson, “Price/Earnings Ratios and Expected Returns,” Journal of
Financial Planning, February 2002.
4
The projected P/E was 69.1.
China Stock Market in a Global Perspective
41
DOW JONES INDEXES
September 2002
Because both are contributing factors, prices or earnings figures are the
source of any extreme P/E ratios. An extremely low price in October 1979
pulled The Dow’s P/E down to 6, while in August 1933 the virtual absence of
earnings drove it up to a jaw-dropping 931! To have achieved a normal P/E of
20 at that time, The Dow would have had to close at 2.15, 95% lower than its
close of 40.94 on its day of inception in 1896.
To determine if China’s market is currently suffering from over pricing or
overly low earnings, we will look at another indicator: the price-to-book value
ratio, or P/B.5 As shown in Table 34, while the P/B ratio for the Dow Jones
China 88 Index is somewhat high, it is still well within the normal range,
thereby indicating that low earnings instead of high prices may be the driving
factor for the high P/E in China. Given this, rather than discussing China’s
high valuation or calling it a “overvalued market,” it might be more appropriate to refer to low company earnings or label them “low-profit companies.”
Put in another way, the disproportionate relationship between P/E and P/B
ratios reveals the extremely low profitability of China’s listed companies.
Table 34. P/B of Blue-Chip Indexes in Several Major Markets
No. of Stocks
P/B Ratio
Global
Europe
Asia
Japan
Canada
Australia
HK
50
50
50
100
40
30
30
Singapore China 88
30
88
3.32
2.34
1.82
1.64
2.12
2.42
1.51
1.62
2.43
Source: Dow Jones Indexes. As of January 31, 2002.
Although such factors as economic news, market rumors and speculative
mentality may cause market swings in the short term, it is the company’s
profits and earnings that will eventually drive the stock price. In other words,
a company’s earnings are inevitably reflected by its stock price.
P/E and P/B ratios usually move in tandem within the same industries and
within the same markets, and yet the ratios for China’s stock market deviate
significantly, providing a hint of what has caused the high valuation of the
market. A similar case existed in Japan. As shown in Table 35, the P/E and
P/B ratios of the Tokyo Stock Price Index (TOPIX) were both very high in
1989 as the Japanese market closed at a record high. However, ten years later,
after the bursting of the economic bubble, they moved in opposite directions
—its P/E more than doubled from 71 to 171, while its P/B dropped 78% from
5.4 to 1.2 by 2000. The high P/E and low P/B, after the drastic fall in the
index, indicated that companies were suffering from extremely low earnings.
5
The book value is simply defined as company’s assets minus liabilities.
China Stock Market in a Global Perspective
42
DOW JONES INDEXES
September, 2002
It is a similar case in today’s Chinese market.
The deviation between P/B and P/E shows that
two heavily industrial countries are plagued by
the problem of low corporate earnings. The only
difference is that Japanese companies are in
even worse shape. It should be noted that, while
TOPIX uses a different formula to calculate the
index P/E and P/B ratios, taking the median for
each ratio from among its components rather
than the aggregate, it is still appropriate to use
it for a basic trend analysis within the same
market.
Table 35. P/E and P/B
of TOPIX in Japan
Year
P/E
P/B
2000
170.8
1.2
1999
–
1.6
1998
103.1
1.2
1997
37.6
1.2
1996
79.3
1.8
1995
86.5
1.9
1994
79.5
2.0
1993
64.9
1.9
Like P/E, P/B also tends to vary with sector and
industry designations. The large assets of indus1991
37.8
2.5
trial and financial services companies typically
1990
39.8
2.9
result in low P/B ratios. Japan, with a significant
1989
70.6
5.4
industrial presence, and Hong Kong and
Source: Yearbook of Tokyo
Singapore, both with strong financial services
Stock Exchange.
sectors, have the lowest P/B ratios in Table 34.
China is dominated by manufacturing and industrial companies, but its P/E
and P/B ratios were 48% and 23% higher than those in Japan. This indicates
that China’s stock market is already overvalued, and the problem looks even
worse when the market’s poor corporate profitability is factored in.
1992
36.7
1.8
Another method of measuring a market’s valuation is the market/GDP ratio.
Table 36 shows the eight-year history of China’s market/GDP value, and,
curiously, it is at the low end of the global standard, which would normally
indicate that China’s markets were never overvalued.
Table 36. Ratio of Stock Market Capitalization Over GDP in China
2001
2000
1999
1998
1997
1996
1995
1994
Full-Value/GDP
44.2
53.8
32.3
24.9
23.5
14.5
5.9
7.9
Float-Value/GDP
14.7
18.0
10.0
7.3
7.0
4.2
1.6
2.1
Source: Dow Jones Indexes; Bloomberg; China Statistical Yearbook.
However, this method of valuation measurement comes with its drawbacks.
For one thing, it is inappropriate to compare market/GDP ratios across markets, because capital markets in different countries have different laws, history and culture, all of which can affect market structure. Also, even within the
same market, over time, it is not necessarily a reliable measure. The U.S.
market/GDP ratio broke 100% for the first time in 1957 and has never fallen
China Stock Market in a Global Perspective
43
DOW JONES INDEXES
September 2002
below that level despite the fact that the U.S. market has experienced
numerous market cycles since. And finally, the more than one thousand listed
companies in China are far outnumbered by the tens of thousands of companies that are not listed — a gap caused by the government quota that restricts
the number of stocks listing each year. It makes no sense to compare the
market value of less than 1,500 companies with the total value of products
and services produced by all of the listed and unlisted companies in China.
14. Low Dividend Yield
While the payout percentage and
payout ratios of China’s market are
in the normal range when
compared to the world’s developed
markets, its dividend yield is significantly lower than the average.
Price appreciation and dividend income are the two primary sources of
investment returns. Cash dividend plays a crucial role in long-term investment. The average annual dividend yield since 1930 is 4.3% for the DJIA
with a record high of 10.8% at the end of 1931. This is one of the reasons
global index providers have started to calculate total return versions of their
stock indexes that account for the reinvestment of cash dividends.
An index’s dividend distribution can be measured in three different ways.
Payout percentage measures how many constituent companies in the index
have paid cash dividends in a particular time period. Payout ratio is the percentage of earnings paid to shareholders in cash. Finally, dividend yield
measures the percentage of dividend income from the current investment.
These three measurements are not directly related to each other. But unlike
payout percentage and payout ratio, which are entirely determined by a company’s fundamentals and dividend policies, dividend yield is constrained by
stock prices.
Table 37 summarizes the payout percentage over the past two years for several markets in the DJGI family. At 44.6% the payout percentage for China’s
market indicates that nearly half of the component companies have issued
cash dividends in 2000 and 2001 in the Dow Jones China Index. While this
figure is far below that of Japan or Australia, which both have payout percentages of more than 70%, it is quite close to those for the U.S. and Hong Kong
and even higher than those for Europe and Singapore. According to the current policy in China, no company is qualified for a follow-up or secondary
offering unless it pays a cash dividend. This requirement helps the market’s
payout percentage to stay within a reasonable range.
Table 37. Summary of Index Payout Percentage Over the Past Two Years
No. of Components
U.S.
Europe
Japan
1,676
1,167
704
Canada Australia
203
148
HK
Singapore
China
133
90
549
Dividend Payout
779
464
496
110
112
66
26
245
Percentage (%)
46.5
39.8
70.5
54.2
75.7
49.6
28.9
44.6
Source: Dow Jones Indexes. As of January 31, 2002.
China Stock Market in a Global Perspective
44
DOW JONES INDEXES
September, 2002
Table 38 demonstrates the payout ratios of some blue-chip indexes around
the world. The 43% payout ratio in the Dow Jones China 88 Index is positioned in the middle of the spectrum, suggesting the component companies
paid nearly half of their profits to shareholders as cash dividends. Therefore,
in terms of both payout percentage and payout ratio, China’s market looks no
different from other markets in the world.
Table 38. Payout Ratio and Dividend Yield of Some Blue-Chip Indexes
Global
Europe
Asia
Japan
HK
Singapore
China
50
50
50
100
40
30
30
30
88
Payout Ratio (%)
36.8
51.4
32.8
31.0
39.0
58.6
53.3
41.6
42.8
Dividend Yield (%)
1.58
2.07
1.30
0.86
1.76
3.01
3.02
2.12
0.75
No. of Components
Canada Australia
Source: Dow Jones Indexes. As of January 31, 2002.
Using payout percentage and payout ratio as criteria, a stock market can be
classified into one of four categories. A “many paying more” designation
means many companies pay out a big chunk of their earnings in the form of a
cash dividend. This is true of Australia’s market with its 76% payout percentage and 59% payout ratio. By contrast, Singapore is a good example of the
“few paying less” model, with only 29% of companies paying dividends and a
payout ratio of 42%. Japan falls into the “many paying less” category, because
71% of companies pay cash dividends, but the payout ratio is as low as 31%.
Finally, Europe fits the “few paying more” model. While less than 40% of
companies issued dividends, the ones that did paid out more than half of
their earnings. In China, the 45% payout percentage and 43% payout ratio
look normal and reasonable.
However, as shown in Table 38, China’s dividend yield of 0.75% is dramatically lower than the rest of the world, although its payout percentage is just
slightly lower and the payout ratio even stands at the upper scale in the AsiaPacific region. This yield is also terribly low in comparison with other investment vehicles in China. For example, in the current global environment of
low interest rates, the dividend yield normally exceeds the rate of money
market fund by 1% in developed markets, but in China the dividend yield of
0.75% is far lower than the 3-month CD rate of 1.71%. Such a low dividend
yield may also partly explain why China has the highest savings rate in the
world.
Besides, this is the dividend yield as of January 31, 2002, after China’s market
tumbled 40% from its peak in June 2001. It suggests that at the market peak,
the dividend yield was as low as 0.50%, which the 20% tax on investment
returns would reduce to an after-tax return of 0.40%. Moreover, this is the
dividend yield of the blue-chip index, the Dow Jones China 88. With smaller
China Stock Market in a Global Perspective
45
DOW JONES INDEXES
September 2002
stocks included, a broad market index most likely has even lower yield for
two reasons. First, the smaller a company is, the lower the possibility that it
will pay a meaningful dividend. And second, speculation and manipulation in
China’s small-cap market means the stocks are more likely to be overvalued.
Traditionally considered value stocks, manufacturing companies tend to have
higher payout percentages, payout ratios and dividend yields, compared with
technology-oriented “New Economy” firms. As a consequence, all three figures are always higher in the DJIA than in the S&P 500, which in turn has
higher results for those figures than the Nasdaq Composite Index. With this
in mind, it seems even more unusual for China’s industrial-driven market to
have a dividend yield as low as 0.75%. But it does provide additional evidence of the low profitability and high valuation of China’s equity market.
Since the payout percentage and payout ratio are both within the normal
range in China’s market, its low dividend yield can only be driven by excessively high stock price or excessively low corporate earnings. To raise the dividend yield, the ratio of cash dividend to stock price, either the dividend
must rise or the stock price must drop. The Chinese government regulates
that no listed company is eligible for a secondary rights issue unless its rate of
return exceeds 6% for three consecutive years. This policy has prompted
some companies to lower their net asset value by paying out more dividends,
thus paving the way for a share increase in the future. But despite such
incentives from the government, the dividend yield in China is still considerably low.
The current policy simply stimulates the increase of payout percentage in the
market, but does nothing to increase the dividend yield. Dividend payments
made for the purpose of raising new capital are a short-term corporate decision, and do not necessarily turn into a long-term dividend policy.
Furthermore, if a company is forced to pay dividends to meet the requirement for raising new capital, it will try to pay out as little as possible and to
stop paying as soon as the goal of new capital is realized. Given this, the low
payout percentage and dividend yield are rooted in the market’s poor corporate earnings.
Additionally, the accounting system and dividend policy in China includes
some different types of “dividends” involving rights issuances and share
exchanges, among other things, that are not accepted as substitutes for cash
dividends in global markets. They lack the value of a regular cash dividend.
China Stock Market in a Global Perspective
46
DOW JONES INDEXES
September, 2002
Conclusions
While China’s stock market has
enjoyed extraordinary growth, that
growth has been very uneven. The
development of a traditional market
structure, increased profitability
among its companies and modification of the government’s supervisory objectives would allow it to operate and compete successfully at
the global level.
China’s stock market has made great strides forward over the past ten years.
In Japan, the number of investors had grown to 30 million as of the end of
2000, from 5 million in September of 1950 when the Nikkei 225 was introduced. In the U.S., 53 million households owned stocks and mutual funds, as
reported by the Federal Reserve in 2000. But in China, the number of investment accounts has grown from nothing to 65 million over a ten-year period.
Also, as shown in Table 39, China is currently well ahead of other emerging marTable 39. Comparison of Several
kets of similar age, both in terms of the
New Emerging Markets
number of listed companies and total marNumber Market Value
ket capitalization.
Country
of Stocks
(USD Bil.)
As a young emerging market, China has its
own unique characteristics. Among the 14
Russia
245
62.9
special features discussed in this research,
Israel
654
63.2
the pyramid structure is the major obstacle
Poland
228
26.8
curbing healthy market growth and standCzech
138
9.7
ing in the way of developing tradable
Hungary
58
8.9
index-based products such as derivatives.
Egypt
80
7.1
Therefore, adjustment of the current marSlovenia
130
4.0
ket structure is crucial in reforming the
market. The elimination of these structurSource: Dow Jones Indexes.
al deficiencies will help curb manipulation
As of January 31, 2002.
and speculation, shore up market confidence and alleviate regulatory difficulties and pressures, thus promoting the
sound and continuous development of the stock market. What China’s stock
market needs most at present is achieving long-term stable development,
rather than just getting out of the current plight. Given this, China should
make it a priority to foster and introduce as soon as possible a batch of industry leaders with real profitability, solidify the market foundation and optimize
the market structure.
China
1131
524.3
Not surprisingly, China has a long way to go to commercialize its financial
markets. Increased government supervision, increased profitability of its companies and the development of a normal market structure are three necessary
short- and mid-term goals that must be achieved by China’s stock market if it
is to grow and operate successfully at the global level.
China Stock Market in a Global Perspective
47
DOW JONES INDEXES
September 2002
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48