China's economic achievements have been impressive since Deng Xiaoping introduced "reform and openness/socialist market economy" in 1978 and made his famous "Southern Tour" in 1992: China has delivered a GDP CAGR of 14% since 1990, become the second largest economy in the world (also 2nd largest in terms of market value for equities and bonds globally), managed to grow its per capita income to US$12,588 as of 2021 (US$19,170 in PPP terms), and has the largest asset class in the world in its US$60tn residential housing market.

While the aggregate market cap of Chinese stocks (A shares and Offshore listed combined) has also increased 17x since 2000, the realized equity returns at the headline index level have significantly lagged the strong economic performance: MSCI China, HSCEI, SHCOMP have only gained 0%, -6%, and 3% CAGR in USD terms (-2% to 6% adding dividends) over the past 10 years during which GDP growth was averaging 9% per annum. The realized market returns have also trailed those from major equity markets globally, with SPX, SXXP, TOPIX, and Emerging Markets (MXEF) generating 14%, 6%, 6% and 2% total returns during the same period despite slower macro growth in their respective home markets.

In our recent Global Strategy Paper--The Asian Earnings Enigma--we discussed some potential explanations for the disparity between equity gains and economic growth in China, notably index composition shifts, shares dilution, and compressing profitability due to various macro and sector specific reasons. At a higher level, the issues around regulation tightening targeting the New Economy, the increasing policy/socioeconomic pivot towards socialism and "Common Prosperity" vs. pure market-driven capitalism, and other structural growth headwinds such as a slowing property market, high systemwide leverage, and aging population are also possible reasons for the lackluster equity returns.

While a simple buy-and-hold, beta-oriented strategy in the stock market may not be the most efficient way to monetize the strong economic growth (potential) in China, picking the right themes and sectors in the right cycle has proven to be highly rewarding, as evidenced by the significant realized alpha from Commodity Cyclicals in the early 2000s, Financials in the late 2000s, and Consumer/TMT stocks over the past decade. Dividing the past 2 decades into 4 equal periods based on China's 5-Year Plans, we note that the best-3 performing Industry Groups (GICS level 2) on average gained 275% in each of the 4 cycles, outpacing the worst-3 performing sectors by 311pp and the benchmark by 218pp. In our view, this underscores the importance of embracing active investing (or dynamic tilt for passive investing) in China and proactively shifting investment focuses as the economic and political cycles evolve.

From a policy alignment perspective, they are handpicked by the Chinese authorities for explicit and comprehensive policy support, spanning administrative measures, easier access to capital markets, to tax incentives and direct subsidies.

Sectorally, the listed "Little Giants" mainly reside in Cap Goods, (new) Materials, Tech Hardware, and Semi, all of which are critical to Chinese national security, growth sustainability, and supply chain stability, in our view.

Thematically, they are well synced with, and are essential building blocs to, the "Common Prosperity" vision considering their sector exposures/composition according to our "Common Prosperity" framework.

In terms of market attributes, the listed "Little Giants" carry a strong small/mid-cap flavor in the context of A shares, averaging Rmb7.6bn/US$1.1bn of listed market cap, but with a reasonably strong liquidity profile of US$16mn of ADT.

Fundamentally, they realized 22% top-line and 21% of bottom-line growth in the past 2 years on a median basis, and are expected by Wind consensus to generate 35% EPS CAGR in the next 2 (2022-2024E) years vs. 21% by CSI300. Their historical profit growth track record may not appear as strong as their STAR and ChiNext peers, but they have similar profitability, ROE, and R&D statistics. They on average trade over 21x fP/E on Wind consensus earnings (15x for CSI300), but look attractively priced when their growth potential is taken into consideration, boasting a PEG ratio of merely 0.6x.

While the “Little Giants” story seems compelling to us and could be a major source of potential alpha generation in the years to come, it might not be a practical theme for some investors given its broad universe (703 stocks, 57 sub-industries), small/mid cap bias, limited sell-side footprint, and other corporate governance concerns (e.g. accounting standards, ESG compliance).

As such, we leverage various top-down growth, valuation, and R&D parameters, corporate-governance related considerations such as the breadth of sell-side coverage and management incentive plans, and accessibility factors (ADT and Northbound eligibility) to distill the broad theme into a more confined universe.

The above conditions allow us to screen for 40 names (all Northbound Connect eligible) from 17 sub-industries and form our GS "Little Giant" Portfolio (GSSRCNLG), of which 13 are covered by our equity analysts. Sectorally, 85% of the basket weights are concentrated in Tech (Hardware), Materials, and Health Care. It has an aggregate/average market cap of US$180bn/4.5bn and ADT of US$2bn/61mn, trades on 25x fP/E and 0.8x fPEG, and is expected by IBES consensus to grow earnings by 36% CAGR over the next 2 years. While its absolute valuations look high, the portfolio is trading on all-time lows in fP/E and fPEG terms, both at -2.1 s.d. to their respective historical means.

Our back-test shows that the basket has gained 115% since 2020, significantly outperforming CSI500, CSI300, and MSCI China by 109pp, 123pp, and 146pp respectively. It has demonstrated a beta of 1.1 to CSI500, but only 1.0 to CSI300/ChiNext and 0.8 to STAR, suggesting that it could be an effective vehicle to buy Growth in China without taking excessive beta risk.