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A government-controlled supplier of surveillance equipment is one of the most popular Chinese companies in the world right now, at least with institutional investors. Hangzhou Hikvision, one of China’s so-called A-shares, listed in renminbi on the Shanghai and Shenzhen stock exchanges, is among the stocks to have been selected for inclusion in the MSCI Emerging Markets Index from Friday, obliging asset managers all over the world to consider investing in them.
If the attraction of Hikvision seems obvious — a Beijing-backed business in a booming sector in an authoritarian country — then the other two most favoured A-shares are also telling. One is a drinks company and the other a supplier of electrical appliances — both apparent bets on the rise of China’s middle-class consumer.
Although only 233 A-shares will be added in the first tranche to the index — which is followed by investors controlling $1.6tn in assets — to many, this represents a pivotal moment. Subsequent planned additions are set to radically reshape the global equity landscape.
“Investors can’t ignore China’s domestic market any more,” says Jinming Hu, chief executive officer of GF International Asset Management, the first wholly owned Chinese fund to launch in Europe. “Overseas investors now have no choice but to accept that mainland China’s equity markets are part of the world.”
Many global investors have previously avoided Chinese stocks, partly due to concerns over corporate governance. Even renowned UK stockpicker Anthony Bolton, who arrived in Hong Kong in 2010 to exalted expectations that he would successfully transfer his Midas touch to China, fell foul of accounting scandals and fraud.
He had discovered, as he put it, that corporate governance in China is a “euphemism for ‘are the figures real and is the management lying’”.
The inclusion will force passive funds, which track indices and are held by some of the world’s largest pension funds, to invest in A-shares. Analysts say this has raised fears over corporate governance standards. Some question if this shift of passive, foreign money will force companies to clean up their standards, or whether investors holding these funds could get burnt.
As more A-shares are added into benchmark equity indices, the flows of international capital into Shanghai and Shenzhen could rise sharply. “Based on the experiences of South Korea and Taiwan, after 100 per cent inclusion more than $600bn in foreign capital could flow into the A-share market in the next five to 10 years,” says Steven Sun, head of research at HSBC Qianhai, a Shenzhen-based securities company.
MSCI did not give a timescale for “full inclusion”, but it acknowledges that when that day comes Chinese shares will make up the “heavyweight” portion of about 45 per cent of the MSCI Emerging Markets Index. “When [the Chinese] want something, they do it,” says Sebastien Lieblich, managing director of research at MSCI. “I cannot say if [full inclusion] is going to be in 15, 10 years or five years. Any of these three time horizons are possible.”
While such a prospect appeals to some, it fills others with dread. Active fund managers can select which companies to invest in and which potential landmines to avoid. Passive investors have no choice but to own these stocks.
By objective measurable standards, A-shares are among the most highly-leveraged, volatile, worst governed and most heavily-diluted cohort of shares in any emerging market.
The number of surveillance cameras in operation is set to rise to 626m by 2020, up from 176m last year, according to IHS Markit, a research company. Hikvision, an industry leader, is a beneficiary of the national urge to monitor.
A study by Brandon Emmerich, principal at Granite Peak Advisory, shows levels of indebtedness among A-shares is extremely high. The average gross debt held by a company is 7.8 times larger than that company’s annual ebitda — a broad measure of earnings — while net debt is 6.1 times larger. According to criteria applied by Standard & Poor’s, a credit-rating agency, any company with debt greater than five times ebitda falls into the highest category of corporate leverage.
“Investors need to be very careful,” says Mr Emmerich, whose analysis was based on an original list of 222 A-shares scheduled for inclusion. “The debts of some companies, such as the big property developer Poly Real Estate Group which has debt to ebitda of 18.6 times, are extreme.”
At a time when Beijing is intent on deleveraging its economy, such debt levels represent a risk to investors. High corporate debt can also sharpen a company’s desire to issue more shares, thus diluting that company’s earnings per share — a key measure of value for those invested. Research by Schroders, an asset manager, shows the Shanghai and Shenzhen markets suffer by far the worst levels of dilution among 20 emerging and developed markets.
In terms of governance, as Mr Bolton found, A-shares fare poorly. According to rankings of environmental, social and governance (ESG) standards measured by MSCI, the 233 companies scheduled for inclusion rank far worse than their counterparts in other emerging markets, with 37 per cent scoring the lowest ESG rating available. Just three per cent placed in the top three out of seven ESG categories. “Almost every single international investor I’ve met recently has asked me about A-share corporate governance,” says Mr Sun.
One impact of these poor governance standards is that investors are often blindsided when problems erupt. Leshi Internet Information and Technology, a former star of the A-share universe, fell to earth in April 2017 when it unexpectedly suspended its shares. It took nine months for the suspension to be lifted. During that time, the TV company that diversified into self-driving electric cars suffered a cash crunch and called off overseas acquisitions.
The telling aspect of its demise, however, was that few investors saw it coming; weak transparency rules abetted by lax disclosure allowed the company to effectively disguise its frailties.
Such disregard for minority shareholders is mirrored by the dominant position of majority shareholders. Nearly 70 per cent of A-shares have a major shareholder that owns more than 25 per cent of the company’s stock, compared with just 18 per cent of US firms in which the majority owner is similarly powerful, according to data from Granite Peak Advisory. This weakens the impetus to pay dividends; some 900 A-shares out of a total 3,244 have never paid one, according to Granite Peak.
“Until [MSCI] took the selective approach to A-shares, we were critical about exposing international investors to so much governance risk in China,” says Jamie Allen, founding secretary-general of the Asian Corporate Governance Association. “But even now, it still does increase risk . . . It puts pressure on passive investors to take governance very seriously, and ensure that they’re doing as much as they can. That’s a challenge for the passive industry as they invest in so many companies.”
In spite of this, investors say A-shares represent one of the most compelling opportunities in global equities.
“There are many good businesses listed in the A-share market that are not available [for investment] in Hong Kong, especially in the consumer, industrial and healthcare sectors,” says Bryan Yeo, chief investment officer of public equities at Singapore’s sovereign wealth fund, GIC, one of the largest in the world. “These are the sectors that will benefit the most from China’s focus on producing high quality companies and the growth of the middle income population.”
As the bulls see it, the opportunity is defined by a chance to back the future winners from China’s rise to overtake the US as the world’s largest economy in coming years, carried forward by a middle-class consumer boom, reforms to state-owned enterprises and technological advances in areas such as big data, automation and semiconductors.
Midea’s €4.5bn purchase of the German group Kuka was unpopular in Berlin but made the Chinese appliances group attractive to global investors.
Having been dubbed the “second great transformation”, by Investec, the asset management company says the opening up of the A-shares, “represents a profound shift in focus from volume to value and quantity to quality. The objective is to allow the ‘new economy’ . . . to sustain growth.”
That thinking is reflected in a list of the top 20 A-shares that overseas funds have snapped up over the past 18 months. Of the 20, seven are high-tech firms according to research on 180 emerging market funds by Copley Fund Research, an advisory firm.
The three darlings of these investors, according to the Copley research, are Kweichow Moutai, a premium maker of Chinese liquor, Midea Group, an appliance maker that acquired German robotics giant Kuka in 2017, and Hikvision. Other companies in the top 20 include those involved in the medical, leisure and consumer sectors.
It is revealing, though, that only 57 of the stocks to be included among the 233 have been selected for investment by the 180 funds surveyed by Copley. “The fact that so many A-share companies have been avoided by active managers is a cause for concern for passive investors,” says Steven Holden, the founder of Copley Fund Research.
Those who put money into exchange traded funds have to, in effect, buy all of the stocks that are included in an index and thus are likely to have a much broader exposure than active stock pickers who invest in only a few companies after close scrutiny of their prospects.
The danger inherent in the passive approach to A-shares is that some of the many companies that make up an index may fail, undermining overall performance. This risk is heightened by a strong proclivity among A-share companies to suddenly suspend trading.
One of the world’s most valuable liquor companies has become a popular investment opportunity in China
In July 2015, when China experienced a sharp market sell-off, more than 1,400 companies, about half of the total listed, suspended trading. Even though the situation has improved, MSCI conceded in 2016 that the number of trading suspensions in the China A-shares market remained “by far the highest in the world”. The index provider has imposed a rule preventing companies that have been suspended for 50 consecutive days or more from being included in the MSCI EM index.
“There were problems around governance and when things got shaky in 2015 many companies suspended their shares,” says Dale Nicholls, manager of Fidelity’s China Special Situations trust, the fund once run by Mr Bolton. “That was a problem but actions have been taken. There is still obviously room for overall market governance to improve but changes have been made and it’s now much more difficult for companies to suspend their shares and keep them suspended for so long.”
Z-Ben Advisors, a data and analytics company, says there were 211 stocks suspended as of the end of May. “This issue is unique to China; most other countries don’t have significant trading suspensions,” says Manishi Raychaudhuri, head of equity research, Asia Pacific, at BNP Paribas. “It makes it a big challenge for passive funds to replicate the index.”
Nevertheless, the size of China and the opportunities it affords mean that investors will ultimately have to get comfortable with the multiple risks.
“One of the biggest changes we are going to see in the next 15 years is the integration of China’s financial markets into the world’s financial markets,” says Henry Fernandez, MSCI chairman and chief executive. “China has the second largest equity market in the world, and the third largest bond market, which is relatively closed to foreign investors. They are beginning to open up. As they open up further the weight is going to increase dramatically.”