Janus Henderson: China investing part 2 - risk, with Chinese characteristics

‘Crows first sense a rising wind, ants first sense a flood’ 
Those familiar with their surroundings are most likely to foresee danger - 
Chinese proverb

Why is there a need for the study?

China’s size, its early stage of development, international ambitions and relatively high levels of corporate debt mean that the country needs vast amounts of development capital for many decades to come. Meanwhile the Chinese government has been consistent in its policy of ‘opening-up’ and moving towards global trading norms. Thus, China both desires and needs a sustained inflow of foreign equity capital for its continuing economic development.

China’s need to attract foreign investment in the global equities markets has at times been hindered by high profile failures in domestic stocks, which has tainted investor confidence. Most of these failures derived from problems in Chinese governance, but they were magnified by the difficulties many global investors face in analysing risk in China. An improvement in the ability of global investors to assess risk has the potential to improve investment returns and increase China’s ability to attract capital. Thus better knowledge provides the prospect of a mutually reinforcing cycle.

What’s different about China?

It is only in the past few decades that China has emerged from a prolonged period of chaos caused by invasion and civil war, and China has only relatively recently reclaimed the ability to act coherently as a nation. This transformation in the capabilities of the Chinese state has coincided with globalisation, a one-off event based on the ideas of free market economics, and dramatic changes in technology. Many observers conflate these two phenomena and attribute China’s extraordinary growth to its adoption of Western economics; but this does not stand up to deeper analysis. For two thousand years, the Chinese economy has relied on a complex interplay between government strategy, state-owned actors and a highly entrepreneurial private sector; it is no different today.

China’s long traditions and continuous civilisation have produced a governance regime that is, in important ways, different from those more familiar to global investors. One example is the ‘chop’ system, which has endured since the Han Dynasty two thousand years ago. In China, corporate action requires the affixing of a company seal, or ‘chop’ to contracts and other key documents. The chop must be registered with Chinese authorities and anyone controlling the chop has wide powers to deal with the company’s assets and its affairs as they wish. The board of directors of a company deprived of its chop is rendered entirely unable to take corporate action, make statutory filings or defend itself against legal action. Thus the physical possession of the chop confers rights and powers that would be unrecognisable in a Western context.

All companies in China are also required to appoint a ‘Legal Representative’, which must be a person appointed as the custodian of the corporate chop, and who has the sole right to enter into binding contracts on behalf of a company. Thus for a company to take effective corporate action, documents must be both affixed with the company’s chop and signed by the legal representative registered with the relevant authorities.

This chop system, coupled with the overriding power of the Legal Representative, has often created a situation in China where, if a board loses control of the chop or faces an uncooperative legal representative, shareholders’ rights can be completely abrogated. Strict adherence to this governance structure is such that, in certain cases reviewed as part of the study, the board of directors of the company was unable to register valid resolutions to dismiss their own Legal Representatives or take other corporate actions, because the outgoing legal representatives refused to sign and affix the chop on their own dismissal documents with local authorities, effectively holding the company to ransom. Moreover, there have been countless attempts by foreign directors to use the court systems to force disgruntled legal representatives to return a company chop, none of which have ever been successful.

The role of the State in equity markets

On a macro-level, the stock markets in China are used as a tool for the State to realise its strategic aims; thus they are not as market driven as in the West and are subject to two specific controls that are absent from the Western model.

Firstly, the government regulates the markets closely by controlling the flow of companies that are allowed to list both on the domestic markets and the global stock exchanges. Important state-owned enterprises that contribute to the realisation of government development strategy will find it much easier to access both the international equity markets and domestic debt. Consequently, the domestic equity markets, while providing an important source of wealth for Chinese investors, are essentially an instrument for realising national strategy and this strongly influences the way they are governed and regulated.

Secondly, the participation of foreign investors in China’s economy is strictly regulated by the Ministry of Commerce, which publishes an extensive list of prohibited areas where foreign investment is restricted or excluded entirely. Certain large Chinese companies have nevertheless circumvented these restrictions through contractual structures called Variable Interest Entities, which may present investors with an additional layer of risk.

On a micro-level, another example of the role of the State in Chinese governance is its deep involvement in the transfer and registration of share ownership. In China, a company’s ‘business licence’ is the definitive proof of ownership of shares. It is issued by the relevant branch of the State Administration for Industry and Commerce (SAIC) and not, as in the case of a share certificate, by the company itself. This means that the State plays an integral role in all transfers of equity and one cannot, at will, buy and sell equity stakes in People’s Republic of China (PRC) entities, without the approval of the Chinese government.

Purpose of the study

Given the inclusion of Chinese domestic ‘A-shares’ into the MSCI World Index, due-diligence on China stocks is more important than ever for global investors. The different legal and corporate structures and the different governance environment demand that, when analysing Chinese equities, the investment process should be tailored to the reality of the risk environment; and that means placing corporate governance at the heart of risk assessment.

The most important factor for investors to understand is the real intentions in the mind of the controlling shareholder. This is because, in practice, minority public investors have quite weak protection. There are basically two types of business that raise public equity; the first consists of state-owned enterprises (SOEs), and the second are privately owned. For the SOEs, the controlling shareholder is the State and it is important to recognise that it views its long-term strategy as more important than short-term financial gain, although this can sometimes benefit investors. The second type of company is privately held and, due to the historical development of China’s economy, all private businesses were established in the last 25 years; therefore, these companies tend to be dominated by their original founders, who are often highly entrepreneurial risk-takers. It is therefore critical to look for signals that might reveal the real intention in the minds of the founder group.

The core purpose of this study is therefore to equip investors with a framework that can enable them to understand the fundamental question:

How can we properly assess the alignment of interests between the controlling shareholders and the minority public investors?

Scope/methodology

Building on Janus Henderson’s decades of experience of investing in Chinese equities, we have conducted case study analyses on more than 60 Chinese companies with securities listed on the global stock markets, particularly NASDAQ and the Hong Kong Stock Exchange. We looked at companies that endured periods of intense financial stress, such as during a short attack. A short attack is where market participants take a large short position, compressing the stock price, and, if possible, putting the company into bankruptcy. We then examined publically disclosed information available prior to the short attack and identified characteristics of each company’s corporate governance that appeared to determine the eventual outcome.

Where the short attack resulted in substantial destruction of shareholder value, we identified a series of commonly reoccurring indicators of risk, or ‘red flags’. Where the share price weathered the storm and the company went on to prosper, we identified a series of positive attributes, or ‘green flags’. Certain patterns emerged from the data. The intention is that by sharing the results of the study, investors will be better informed as to the risks associated with investing in China.

The flags described in the study should be considered holistically and we aim only to paint a more nuanced picture of the interplay of the various factors that contribute to the state of a particular company’s governance. We do not assert any causal link between flags and outcomes, as this approach would be overly simplistic given the intricacies of the Chinese economy and governance structure. Instead, the study seeks to explore areas of governance that we found to be prone to greater risk in China. For each of these areas, key questions are posed that we believe investors should consider when analysing a particular opportunity. We also ask our investment teams for comment on how they weigh the particular risk and opportunity.

‘Signals and Smokescreens’ will include modules covering:

1. Financial ratios
2. Board oversight
3. Related party transactions
4. Material transactions
5. External oversight
6. Stakeholder relations
7. Variable interest entities

Part 1: Janus Henderson: China investing part 1 - China-specific risk
Part 3: Janus Henderson - China investing - financial ratios
Part 4: Janus Henderson - China investing - board oversight
Part 5: Janus Henderson - China investing - material and related-party transactions