Recently the FT published an article (link) raising the perennial concern about corporate governance in the A-shares market. This is relevant and timely given international investors are currently reviewing their A-shares strategies on the back of MSCI's inclusion decision 2 weeks ago.
Like all hard questions, there is no simple answer to this. In fact, for investors that took a broad brush approach and chose to ignore this market, they might have mixed feelings of awe and regret while watching it become the world’s 2nd largest equity market over the past 15 years. Since the Qualified Foreign Institutional Investor (QFII) scheme was first launched in 2002, China A-shares transformed from a completely closed market for domestic investors only, to a market with increasing participation from foreign institutional investors and now retail investors via the stock connect programme. During this period between 2002 and 2017, the A-shares market recorded a total return of 242.3% (CSI 300), outperforming the US market by 35.6% (S&P 500) and almost doubling the return of the European markets (Euro Stoxx 50). Although volatility remained high, history shows that China A-shares are rewarding to long-term investors. At the end of the day, the equity market follows the macro economy and there are indeed listed Chinese companies that have been creating long term value for shareholders and over-compensating for the ones that are weeded out during the structural transformation of the economy.
Figure: A-shares (CSI300) performance vs S&P500 and Euro Stoxx 50 since QFII began in 2002
Corporate governance issues are not new or unique to China. They exist in every emerging market and also developed market. In fact, in many ways the world is still recovering from the value destruction and contagion from the global financial crisis, the collapse of Lehman Brothers and the likes, or Enron and Worldcom further in the past. To implement any reform agenda for a US$10 trillion economy with 1.4 billion population is a daunting task that takes a journey instead of overnight transformation. The topic of corporate governance is still on the agenda in many markets, including developed ones - one needs to look no further than Japan's Stewardship Code efforts to understand that it is a long-term project. The Chinese government and regulators have been stepping up the effort to ensure a fit and proper corporate governance is in place for the listed companies. For example, if the stake of the controlling shareholder exceeds 30%, a cumulative voting mechanism must be adopted to ensure that the voting interests of minority shareholders are given appropriate consideration. In addition, since June 2003 one-third of the board members must be independent directors. On the other hand, China’s Ministry of Finance implemented major reform for accounting standards, stipulating that by 2007, all listed companies must adhere to new accounting standards that substantially conform to International Financial Reporting Standards (IFRS). The list continues, and we foresee that corporate governance of Chinese listed companies will continue to improve along with increasing ownership from domestic institutional investors and foreign investors after MSCI inclusion.
Another common concern is the broad brush shunning of State-owned Enterprises (SOEs) spilling over to the entire China A-shares market. First of all, it is worth noting that out of 3,272 listed A-shares companies in Shanghai and Shenzhen exchanges, there are only 1,001 central or local SOEs, accounted for less than one-third of total number of listed companies. There are in fact a lot of listed companies for investors to select from the whole universe if they prefer to invest in non-SOE enterprises. Having said that, it is perhaps unwise to completely neglect the SOE sector, which still contributes to the foundation of the Chinese economy – the stock of the country’s GDP today. It is also overly simplistic to say that all SOEs are in a bad shape, mismanaged or over-geared without proper due diligence. For example, Gree Electric is one of the local SOEs growing from a provincial home appliance producer in Guangdong, to now the world’s largest residential air-conditioner manufacturer and a flagship white good company that continues to lead and reinvent itself. Gree's return-on-equity has been steady ~30% consistently in the past decade whilst the latest debt-to-equity ratio is 36.4% only. The stock was a 10-bagger if holding it for the past 10 years! It’s exactly the kind of stock that Peter Lynch would have picked by looking around at home or in the shopping mall. SAIC Motor is another example. It was one of the few carmakers from Mao’s China, among the first making the Shanghai SH760. Now it is a Fortune Global 100 company and one of the big four State-owned Chinese automakers producing brands like Shanghai Volkswagen and Shanghai GM, benefiting and contributing to megatrends such as consumer upgrade and urbanization of the country. It has always been profitable since listing in 1997. SAIC Motor recorded a return of 252% in the past 10 years compared to a 5% return of the A-shares market.
Figure: Gree Electric – a 10-bagger!!
Figure: SAIC Motor outperformed the market significantly in the past decade
Excluding SOEs is not an option. Nor is simply buying all of them or the largest ones by market cap without any screening or selection. What is important for investors is how to capture the current contributors and engines for future growth of China's economy whether the underlying stocks are SOEs or non-SOEs. One may rely on the brain (luck?!) of active managers in generating alpha or investing in traditional passive index products to gain the market beta performance. At Premia Partners, we think there is a better approach that is more prudent and fitting, applying a rules-based fundamental methodology to stock screening/selection in a systematic way. Instead of applying global factor models to optimize for a single factor such as momentum or low volatility, we use fundamental rules to screen out companies that don't make long-term sense. These rules result in consistent value, quality, low vol and low size exposures that lead to better results.
- high revenue ex govt subsidies
- high profitability & margins
- high R&D investment
- new economy and high growth firms
What doesn't work:
- high debt
- high volatility
- lots of earnings management
- high fixed assets
The above screens might be obvious to most, yet no strategies exist to systematically implement them. Using research from the last 22-years of China A-share market behavior, we believe a fundamental, rules-based and transparent approach makes the most sense. Unlike most offerings available today, we don't start with FTSE A50, CSI 300 or MSCI China A and then tilt a bit here and there. We start bottom-up from the 1,500 most liquid stocks in China and then narrow the universe down to our desired stock characteristics. This approach has allowed us to create 2 strategies - roughly 300 stocks each - focused on China's bedrock economy (stock of today's GDP) and on China's new economy (majority of future GDP growth). Both are designed to not only outperform with similar levels of risk, but to avoid the minefields above without using blunt inclusion/exclusion rules. We'll share more in future write-ups, but don't hesitate to let us know should you have any questions or like more details about our plans.