Key takeaways

• From electric vehicles (EV) and healthcare, to automation and green tech, China is transforming the way its citizens live and work – and innovative, market-leading small- and mid-caps (SMID caps) are driving this revolution.
• SMID caps are nimbler than their larger peers, able to adapt quickly and exploit the multitude of opportunities across both new and established sectors.
• Despite these factors, most investors ignore SMID caps – meaning this is an untapped, relatively cheap1 and compelling long-term investment opportunity.

The international participation in Chinese markets has grown rapidly in recent years. However, for many investors, this usually only extends to megacap names like Alibaba or Tencent. However, dig deeper and you’ll find China offers a largely ignored, but fast-growing and compelling investment opportunity – SMID caps.

Why consider SMID caps?

Given their size, SMID caps are often nimble, able to adapt quickly to market and societal changes. This means they can unlock new opportunities or fill the void left by their bigger rivals. These growth opportunities tend to be large relative to the size of the company, leading to impressive revenue and profit growth. This compares to China’s large- and megacap firms, which tend to exploit more mature growth opportunities.

Take the consumer sector. China has a huge domestic retail market, which is growing alongside rising incomes. By our numbers, the consumer sector will quadruple to US$30 trillion by 2050.² In particular, China’s lower-tier cities are seeing explosive growth in demand. However, many of China’s internationally focused consumer giants are largely absent here. This creates opportunities for businesses able to establish themselves in these markets.

One example is TongChen Travel, an online travel agency. It offers transportation, ticketing and hotel services for luxury interprovince travel. The company primarily targets mid- to lower-tier cities (according to the company, more than 80% of its registered users live in non-tier-1 cities). We expect demand in this sector to grow as the increasingly affluent middle-classes travel. Elsewhere, Meidong Auto is a luxury car dealer focusing on tier-3 to -5 cities. Strategic brands include Porsche, BMW/mini, Lexus, and Audi. It has a ‘one city, one store’ strategy that seeks to avoid store cannibalisation and maintain a high operating efficiency.

What’s the investment opportunity?

Many SMID caps are the primary drivers of innovation in China. They lead the way in areas like industrial automation, healthcare equipment and complex parts of the electric vehicle supply chain. Our research found that SMID caps are also responsible for 65% of Chinese patents, as they continue to evolve to meet and shape future markets.

Companies to highlight include Centre Testing International, which offers quality assurance for sophisticated manufacturing and electronics. Then there is Amoy Diagnostics. It has some of the most advanced gene testing equipment in China. Amoy also has first-mover advantage in this field and is one of the leading providers to domestic hospitals.

Meanwhile, China, with its ageing workforce, is aiming to automate sections of its manufacturing base to maintain its competitive advantage on the world stage. On the back of its Net Zero 2060 pledge, the country is also seeking to reduce its reliance on fossil fuels. To meet these aims, there are a wealth of SMID caps providing solutions to tricky problems that require sophisticated engineering solutions. Names here include OPT Vision Tech (components and software for factory automation) and Jiangsu Cnano Technology (nanomaterials used in EV battery manufacturing).

Why now?

Earnings in many SMID cap-dominated sectors – tech, aspiration, health & wellness – look set to remain strong through 2023/24. We forecast many stocks will deliver 30%-plus earnings per share next year³, despite global and domestic macroeconomic headwinds. And yet, international investors often overlook SMID caps. Analyst coverage remains scant, even by small- and mid-cap standards. On average, most brokerages have only two analysts covering the 3,000-stock SMID cap sector. This lack of data means market valuations are often inaccurate. SMID caps are also usually cheaper than their global peers as a result. The MSCI China All Share’s SMID Index trades at 0.9x price to book, the S&P 500 at 3.5x¹.

Should you worry about regulatory tightening?

Not as much as the headlines might suggest. Indeed, the Chinese government recognises the country needs highly innovative companies to meet many of its policy objectives. Priorities include addressing the demographic decline, making healthcare more accessible and encouraging domestic savers to return to the market.

The regulatory environment is consequently supportive for SMID caps. This contrasts with some segments of the large-cap world (real estate, education), which have been rocked by hard-hitting interventions. The government has also opened exchanges to channel overseas capital into SMID caps. In 2019, they launched the Shanghai Star Market. Heralded as ‘China’s NASDAQ’, the Index has 400 listings with a US$1 billion cap or more, with constituents focused on tech and innovation. Interest is growing. The Index launched more than 20% of Chinese IPO activity by value in 2021. The similarly focused Beijing Stock Exchange followed the Star market two years later.

A note of caution

There are pitfalls to investing in SMID caps. As we highlighted, analyst coverage is often found wanting. Information is sparse, so due diligence is time consuming and costly. Furthermore, governance risks are higher with SMID caps than their larger equivalents. The small and micro-cap founder or family run businesses can be of particular concern. Poor or mismanaged companies can sometimes go unnoticed until it’s too late.

There’s a plus side, however. Investors with on-the-ground resources to meet management teams and other key decision makers can often gain an information advantage over rivals. This means there are a wealth of potentially mispriced opportunities in the SMID cap universe. For our part, we also tend to focus on the larger end of the market cap spectrum, where we find higher standards of governance and better ESG standards.

Final thoughts...

So, can investors afford to ignore small- and mid-caps? In our view, the answer is a resounding no. Many innovative firms are leading the charge in areas like green tech, healthcare, automation and more. Others are able to take market share from bigger rivals, notably in the consumer space. That’s why we believe many of today’s SMIDs will become the giants of tomorrow. With valuations relatively cheap, now could be a good time to consider SMIDs as part of a wider portfolio.

To learn more about our China strategies, click here.

Companies are selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance. Past performance is not a guide to future results.

¹Source: abrdn: October 2022

²Source: abrdn Research Institute, January 2022

³Source: abrdn, October 2022.