Dear Investors and Friends,

This letter includes a special topic—China stock‑market returns and the impact of EPS dilution—exploring why, despite being the fastest‑growing economy globally over the past four decades, the equity market has performed poorly in aggregate. We also explain why we believe, first, that selective opportunities in China are compelling and, second, that even aggregate returns may improve in the future.

 

Chinese equities have recently come back into favour, with the MSCI China Index up 34% over the past year. We at Variis are also bullish, but as always highly selective, with about one-quarter of the strategy invested in China. In this context, it’s worth examining why China has, over the past three plus decades, been one of the worst-performing major markets – and how that might change going forward. In USD terms, MSCI China has returned roughly 2.1% annually over the last 10 years, and only about 1.4% annually since its inception in December 1992. We analyse the objective reasons for China’s poor long-term equity performance and consider whether these issues are structural or transitory. Our conclusion is that:

• Rapid growth encouraged equity dilution: China’s era of rapid GDP growth (now largely over) drove funding needs that led many companies to issue new shares, diluting earnings per share and sapping equity returns.

• Valuations fell but are attractive now: A long-term de-rating of valuation multiples also weighed on historical returns, but today China trades at only ~11× forward earnings (versus ~19× for global equities), creating a favourable valuation backdrop.

• Capital allocation matters: Careful stock selection – particularly regarding management’s capital allocation and funding decisions – is critical for success in China.

 

Why have China’s equity returns been poor?

Many investors, including professionals, don’t appear to have a rigorously analytical understanding of what has driven historic Chinese equity performance. People often fall back on heuristics or anecdotes – for example, claiming “GDP growth and market returns are unrelated,” or blaming issues like fraud, state-owned enterprises, or excessive competition. In this letter, we instead present the unvarnished math of what happened, then consider narratives that fit the facts. More importantly, understanding why the market hasn’t delivered helps inform how to pick Chinese stocks that can generate returns.

 

Since 2000, China’s nominal GDP (in USD terms) has increased about 14-fold, far outpacing the rest of Emerging Markets. Over the same period, the aggregate profits of companies in the MSCI China Index grew even faster – Chinese corporate earnings were exceptional, even outpacing earnings growth in other EM countries. Yet earnings per share grew much more slowly. The adage that stock prices follow earnings is only partly true; we must also consider valuation multiples and changes in share count.

 

The Chinese market’s valuation has de-rated over time. The MSCI China forward P/E is around 11× today, roughly in line with its 10-year average but down from about 20× in the early 2000s. This long-term multiple compression has been roughly a 200 basis-point annual headwind to shareholder returns over the past 25 years. Notably, China’s ~11× P/E is well below the MSCI ACWI’s ~19×, underscoring its attractive relative valuation at present.

 

However, the single largest factor separating China’s exceptional economic growth and robust corporate earnings from its poor shareholder returns has been share dilution. In short, listed company EPS has been persistently diluted by new equity issuance. For the MSCI China Index, EPS growth has significantly lagged both nominal GDP and aggregate net income growth. Over the past 25 years, EPS growth trailed nominal GDP growth by about 500 basis points per year on average – resulting in only mid-single-digit EPS growth despite double-digit GDP growth. It’s no surprise, then, that long-term equity returns have been so weak.

 

Understanding EPS Dilution in Greater Depth

Index-level EPS dilution stems primarily from new share issuance by index constituents. Simply put, companies issue additional shares when internal resources aren’t sufficient, and equity financing is deemed more attractive than debt financing. Sometimes this dilution is camouflaged – for instance, via convertible bonds (which boost share count upon conversion) or excessive stock-based compensation (which can leak value to management).

 

The data show that EPS dilution has been the key culprit behind China’s poor equity returns. If this historical pattern of dilution is now changing, it will have major implications for investors. (For perspective, MSCI China’s ~low single digit percentage annual USD total return can be broken down into roughly 5% EPS growth minus several percentage points per year from multiple contraction.)

 

This phenomenon is not unique to China. Bernstein and Arnott (2003), for example, found that in the 20th-century U.S., net share issuance of about 2% per year caused corporate earnings growth to lag nominal GDP growth by roughly 2% annually. Likewise, China’s decades of extraordinarily high GDP growth were accompanied by exceptionally high net equity issuance – resulting in much slower EPS growth than headline economic growth.

 

 

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By contrast, the United States in recent years has experienced substantial net share buybacks (yielding EPS accretion that helped fuel strong returns), while most other Emerging Markets have seen only slight net dilution. China, however, stands out for pairing its rapid economic growth with unusually high EPS dilution.

 

Importantly, China’s disappointing EPS growth is not simply due to index composition changes like IPOs or the unlocking of restricted shares. Such events increase both the index earnings numerator and share count denominator proportionally (via free-float adjustments), so they do not create an EPS growth gap.

 

The Micro-Economics of EPS Dilution

At the micro level, EPS dilution comes down to managerial choices and incentives. China’s development model long emphasized growth through heavy investment – a strategy that eventually hit diminishing returns. During the decades when nominal GDP was growing above 10% (the 25-year CAGR was ~12%), listed companies with ROEs around 11–12% often needed to raise equity capital to fund expansion. Many firms issued new shares and grew their net income rapidly, but because their share counts kept rising, their EPS growth lagged far behind.

 

Now that nominal GDP growth has slowed to ~5%, the average company’s reinvestment needs no longer exceed its retained earnings. In this environment, dilutive equity issuance should logically be much lower going forward.

 

Years of heavy investment have driven the MSCI China Index’s ROE down from the mid-to-high teens in 2004–2014 to ~11–12% today. This decline – combined with all the share issuance – indicates that much of the incremental capital was poorly allocated (companies raised money, but the returns didn’t compensate for the dilution). In effect, a great deal of capital was wasted on expansion for growth’s sake – a phenomenon the Chinese refer to as “involution,” meaning relentless competitive investment with minimal returns. Many firms continued to invest simply to meet growth targets, diluting shareholder value in the process.

 

To illustrate the impact of dilution, consider LONGi Green Energy, a major solar equipment manufacturer. LONGi IPO’d in Shanghai in 2012, and since then its share count has expanded by 82% as the company repeatedly issued equity to fund expansion beyond what its internal resources could support. Over the ten years from 2016 to 2026, LONGi’s net income is expected to grow roughly in line with China’s nominal GDP – but its EPS has been diluted by more than 4% per year. LONGi’s story exemplifies the broader Chinese market: strong underlying business growth, but per-share returns eroded by heavy equity issuance.

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What Happens Next? Evidence for Change

China’s dilution problem has rarely been acknowledged publicly. The issue has been largely ignored in local market analysis: for example, a top Chinese brokerage told us it has no research reports on index-level EPS dilution, and a search on Wechat for “EPS dilution” in Chinese yields virtually nothing. This silence is surprising given how critical dilution has been. Policymakers are certainly aware of the problem (the recent stimulus package even included central-bank funding for share buybacks), but dilution is likely a politically sensitive topic – if the market has effectively been an unremunerated piggybank for companies at the expense of household investors, that’s not a narrative that officials are eager to broadcast.

 

Despite the lack of open discussion, we see reasons to be optimistic that the next chapter for Chinese equities will be much better. Three developments suggest that EPS dilution will moderate significantly – or even reverse into accretion – going forward:

• Slower growth means less dilution: Nominal GDP growth has downshifted to a mid-single-digit pace, which means companies generally no longer need to issue equity to finance growth. Lower economic growth will naturally temper profit growth, but whatever growth does occur is more likely to accrue to existing shareholders rather than be diluted away.

• Shifting corporate behaviour: Corporate behaviour around shareholder returns is already changing. Share buybacks in the domestic A-share market have surged – the pace of buybacks in 2024 is nearly double the average annual level of 2020–2023, reaching roughly 1% of total market capitalization.

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• Policy support for buybacks: Regulators are actively encouraging buybacks. The stimulus plan announced in late September 2024, for example, included a RMB 300 billion (approximately 2% of A-share market cap) facility funded by the central bank to incentivize corporate share repurchases at a subsidized 1.75% interest rate.

 

As a result of these trends, we expect MSCI China to experience much lower EPS dilution going forward – potentially even EPS accretion if buybacks continue at scale. With China’s leaders keen to bolster household wealth amid a weak property market, it makes sense for policymakers to support a healthier stock market that can deliver a positive wealth effect.

 

In June 2025, we asked a Vice President at the Shanghai Stock Exchange about the pace of buybacks this year. He not only recognised the importance of the dilution problem, but said that based on his communications with the constituent companies, as well as his understanding of policy makers guidance, that 2025 buybacks will be significantly larger than those in 2024.

 

Selecting Stocks to Avoid Dilution

The lessons from China’s past inform our investment approach today. At Variis, we explicitly evaluate management’s capital allocation – especially their history of issuing or buying back

shares – as a key part of our quality assessment. We invest only in Chinese companies where we are aligned with owner-managers on capital allocation.

 

 

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Our analysis indicates that the Chinese businesses we invest in are led by managers who are unlikely to dilute shareholders. In fact, many of these companies are doing the opposite: they are actively repurchasing shares at value-accretive prices (see table above). We therefore expect that the fundamental growth in our portfolio holdings will translate into enhanced per-share returns.

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Conclusion

We are proud of the business we are building and the long‑term partnerships we are fostering. The past quarter has demonstrated the strength of our investment philosophy: a disciplined focus on high‑quality, scalable businesses, deep local knowledge, and a willingness to be contrarian when appropriate.

 

Our team remains committed to delivering strong returns through bottom‑up stock selection and active portfolio management. We believe Emerging Markets are at a pivotal juncture, and we are well‑positioned to capitalise on the many opportunities that lie ahead.

 

Finally, we remain deeply grateful for your trust and support. Your partnership enables us to stay focused on what we do best: identifying exceptional businesses and investing with conviction. We look forward to updating you again next quarter.

 

Thank you for your continued interest and support!

 

Leila, Eko, Rufus and Jamie

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Disclaimer

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FOR PROFESSIONAL INVESTORS AND ADVISORS ONLY

The contents of this document are communicated by, and the property of, Variis Partners LLP. The information and opinions contained in this document are subject to updating and verification and may be subject to amendment. No representation, warranty, or undertaking, express or limited, is given as to the accuracy or completeness of the information or opinions contained in this document by Variis Partners LLP or its directors. No liability is accepted by such persons for the accuracy or completeness of any information or opinions. As such, no reliance may be placed for any purpose on the information and opinions contained in this document. The information contained in this document is strictly confidential and is not intended to be advice or an offer or solicitation to invest. The value of investments and any income generated may go down as well as up and is not guaranteed.