Last year our fund managers made 190 company visits to the mainland, and that’s not including the meetings with management teams based in Hong Kong, from where we do the majority of our China research.
Aberdeen has always liked the China story: the rise of the middle class, urbanisation, high savings rates and pent-up demand.
But the one thing that has always prevented us from jumping in with both feet has been the poor quality of many of the companies we find there.
Corporate governance – or to be more precise, its absence – has been the single most important stumbling block for us.
That’s why we still advise our clients, as a first step, to access China’s growth via companies that are listed offshore (usually in Hong Kong) where rules designed to protect investors are more rigorously enforced.
At times like this, when local currency A-shares trading in Shanghai and Shenzhen have risen nearly 80 per cent in six months, it’s easy to throw caution to the wind.
The markets may be frothy but there’s always a greater fool, right? Clients demand answers when their investments lag the benchmark.
When greed trumps fear, investors would do well to remember that of the 2,000-odd companies in the A-share universe, only 700 or so are regularly researched by analysts.
When it comes to the rest, very little is known. What we do know is that some are in such bad shape that only state-directed loans (financial lifelines designed to protect jobs and the savings of countless small investors) keep them afloat.
‘Creative’ accounting
This is a market where not doing your homework can be disastrous.
Successful fund managers who cut their teeth in a developed market may find themselves in trouble when they rely too much on numbers that later turn out to be fictitious; when they accept what they’re told at face value; or when they find themselves on the wrong end of flagrant market manipulation.
Careful due diligence can often unearth outrageous abuses.
We once found out that the wife of a member of the senior management at a listed company was running a similar but unlisted business – the two companies shared research and development resources and that some of the best products from this program went to the wife’s company.
Investors are either oblivious to the arrangement, or simply don’t care, as the listed company still trades at some 40 to 50 times earnings.
This flagrant disregard for the interests of shareholders tends to be the rule, rather than the exception, which is why most Chinese companies fail our quality control tests.
Read enough profit-and-loss statements and you become sensitive to any big numbers filed as ‘selling, general and administrative’ items, where the costs of unspecified ‘corporate entertainment’ can be tucked away.
There’s the classic trick of artificially extending the period over which asset depreciation is calculated to boost the value of assets on the balance sheet.
In the case of China’s banks, looking for signs of trouble off-balance sheet is often just as important as poring over the published data.
Does the current rally have legs?
This is almost impossible to answer with conviction because the link between company earnings and share prices has completely broken down. These gains simply defy conventional investment analysis.
Much hinges on whether retail investors in China continue to believe their government will launch new measures to cushion a slowing economy and support asset prices. But these small investors can be unpredictable.
For example, stock prices hardly reacted to the recent decision to free up more cash for lending at the commercial banks (by cutting the so-called ‘reserve ratio requirement’), a move that should have sent prices higher.
That’s why we’re playing it safe by doing what we’ve always done – looking for good-quality companies at reasonable prices.
When an investment runs up too much, we trim our holding and reinvest the cash elsewhere.
When it comes to A-shares (the shares of companies incorporated in mainland China and traded in Shanghai or Shenzhen, quoted in Chinese Renminbi), despite all the pitfalls, we feel there are a handful of companies that deserve serious attention.
Some are companies that remained off-limits to foreign investors for many years and have therefore largely escaped their notice.
Some are even large state-backed industry leaders that were among the first Chinese companies to adopt international management practices.
All of them have, despite the odds, overcome every conceivable reservation that we have about Chinese companies.
Granted, it’s hard to buy A-shares now without overpaying, but shares of the same companies that are listed in Hong Kong trade at a significant discount, and there is some flexibility for us to select the cheaper option where appropriate.
The A-share rally may be a towering edifice built on sand, but there are companies that have successfully navigated repeated cycles of boom and bust, arbitrary access to credit and unpredictable officialdom.
They are here for the long term and are well placed to benefit from comprehensive structural reforms that will lay the foundations for the next stage of China’s growth.
Nicholas Yeo is the director and head of equity, Asia, at Aberdeen Asset Management.
