Who ate all the Chinese stock market returns?

Long-term nominal GDP is the stuff earnings are made of. And emerging-market economies grow faster than developed ones. Put these two facts together and the case for long-term allocations to EM equities has looked compelling.

But no matter how compelling, it hasn’t really worked for a long time. And it has singularly failed to work for investors in Chinese stocks over the past 25 years. While the biggest global economic story of the last three decades has been the rise and rise of China, Chinese stock price performance has been . . . well, a bit rubbish:

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Each dot represents a different emerging market. The further you move right across the chart, the faster the economic growth has been in US dollar terms. The further you move towards the top, the stronger bigger the equity price gains, after taking into account local currency changes against the US dollar.

If you’d known China’s nominal GDP growth in US dollar terms would grow 27-fold over thirty years, you’d have maybe assumed Chinese stocks would be the standout asset class. As the red dot to the bottom right shows, this would’ve been an expensive assumption.

What happened? EM Advisors, a boutique emerging market research firm, has put out a terrific report on just this topic. They found Chinese companies haven’t struggled to make oodles and oodles of money, but equity investors have still been stiffed along the way.

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Since 2002, earnings per share have compounded at a strong single-digit pace — which isn’t bad. But total listed earnings have grown at an annualised rate of close to 14 per cent.

What’s the difference between earnings and earnings per share? Hmm. Maybe something to do with the total number of shares.

Stock markets are dynamic, so what looks like dilution at a headline level could actually just be new enterprises being formed and listing, or even existing companies graduating from microcap indices into larger cap indices. This happens all the time across the world: if we rewind all the way back to 2000, five of the Mag7 weren’t even in the S&P 500.

But here’s a chart showing the market cap of local Shanghai and Shenzhen exchanges from 2000 by category:

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Dark blue bars at the bottom show the market cap of the firms that were around in 2000 if these firms’ stocks had just performed in line with the market. Light blue shows the same for all the new companies that have IPO’d since then.

Medium blue bars captures all the official secondary issuance since 2000. And these medium blue bars are where we’d normally expect dilution to occur — think rights issues, that kind of stuff. And these medium blue bars total more than the dark blue bars of original market cap and light blue bars of IPOs. But what’s with the red?

Red bars can be thought of as a kind of stealth dilution: the conversion of various non-tradeable share categories into tradeable shares, and internal creation of new shares to monetise holdings. Formally, it’s the unexplained residual. It’s the sort of thing that investors couldn’t really have seen coming. And it’s bigger than all the other sources of market capitalisation put together. Oof.

But while local shareholders look like they’ve had much of the upside of Chinese economic growth taken from them, this form of dilution has at least pretty much petered out.

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Previous waves of dilution each came when Chinese stock markets were going wild to the upside.

In the year to September 2007, Chinese stocks quadrupled, and management collectively pumped out a dilution equivalent to a quarter of the total market cap of the Shanghai and Shenzhen markets. It’s almost like the game is rigged against capitalist speculators trying to make a quick buck out of companies based in a one-party communist state.

Is this form of stock dilution dead? It has certainly collapsed of late. Perhaps what we’ve seen were birthing pains from a young market finding its place in the world. It’s hard to say until the next monster bull run in Chinese stocks.