Impending A-share access seen posing challenge

Minority investors in Chinese family-owned companies must somehow evaluate intangible assets if they are to avoid losses, warns a professor at the Chinese University of Hong Kong.
Impending A-share access seen posing challenge

Congratulations, you are now on the verge of adding China A shares to your emerging-market or global equities portfolio. You are pleased because they offer low correlations and, you hope, plenty of upside. Now comes the interesting part: how to pick stocks in China.

The delayed but still impending launch of Stock Connect (linking trading of certain stocks and futures on the Shanghai and Hong Kong bourses) will further open the door to foreign investment in A shares. According to an experienced researcher of family-owned businesses in Asia, investors accessing mainland-listed companies will need to understand those family dynamics – a truism that will be especially powerful in the A-share market.

“In addition to financial reports and the fundamentals, investors need to look at a company’s intangible assets, which are really the key to its success and sustainability,” said Joseph Fan, a professor at the Chinese University of Hong Kong.

That means understanding: “Who’s the boss? Is it someone you can trust? Is their success based on political relationships?”

There are quantitative ways to look for companies that may not have a sustainable business model, Fan said. For example, analysts can see from a financial statement whether the company is diversifying into non-core business areas such as property development or government projects.

“These are signs of rent-seeking,” Fan said. “Rent-seeking can be profitable, but if a business owner is engaged in a lot of this sort of thing, is this someone who will give [minority shareholders] a fair share of the profits on a long-term basis?”

Other metrics can gauge whether a company’s founder is trustworthy, even when data in mainland China is scarce.

For example, Fan has examined 40 large companies listed in Greater China, including Hong Kong and Taiwan, in the food retailing sector, which can run from restaurant chains to milk producers. In China, food safety is a big issue. Among these listed companies in Greater China, on average, they spend 20% to 40% of their equivalent top-line revenues on marketing and advertising, but only 1% to 4% on research and development, and product testing, found Fan.

“Do not invest for the long term in this kind of company,” he said. “This number reflects the values of the business owner and the business model: these companies are seeking rents from society. Once society learns about it, their stock price will collapse.”

On the other hand, figures can also reveal sustainable business models. For example, a food retailer with a much higher allocation to R&D and testing is probably thinking long-term.

But often it comes down to factors that aren’t in the financial statement that determine whether a company emphasises sustainability.

Children are a key indicator, Fan said. Families that bring their children into the business at an early age and at a low level, forcing the kids to learn the business, are planning for the long haul. Families that parachute a child (perhaps fresh out of a second-rate business school in the US) into a senior management position are more likely to run an unsustainable business.

Similarly, families that cultivate a company’s professional management and can promote such people into senior roles are building a sustainable franchise. Those that need to hire a CEO from outside, especially in the run-up to a public listing, are short-sighted. Such outside managers are usually there for a short period as well, lured by good money but without a commitment to the business’s future.

A lot of companies, both in China and regionally, are not suited to public listings. Fan said they are pushed to do an IPO by private-equity investors, which in the Chinese context are mostly low-quality, short-term investors looking to exit within two or three years. The reason these companies aren’t really suited to public markets is that their main competitive advantage is relationships, not because of good management or a sharply executed manufacturing process.

Fan helped pioneer research in the 2000s around private, family-controlled companies in Asia. Throughout Greater China and Southeast Asia, virtually all listed companies that aren’t owned by governments are owned or heavily influenced by founding families.

Indeed, this is often the case in developed markets too, and family involvement is often a strength. But from a minority shareholder’s perspective, the biggest problem is transition, when the founder nears retirement.

In 2008, Fan researched over 200 listed private companies from Hong Kong, Taiwan and Singapore. He tracked stock performance from five years before the founder completely exited involvement (including relinquishing honorary chairman roles), the transition year itself, and the three years afterward – a total of nine years per company that experienced such a handover.

After adjusting for broad market performance, Fan found that share prices of companies approaching a transition fell during those five years on average by over 60%; post-transition, stock prices stabilised but never recovered. This represents a massive loss to buy-and-hold investors as well as the business families themselves.

(A number of hedge funds tried to use this revelation to their advantage by developing shorting strategies for companies with elderly founders, but the thinly traded nature of most such stocks made it impossible to consistently make money, Fan said.)

Since then he has aimed his research at privately owned A-share companies. Compared to Greater China, the mainland market is far younger, the state plays a bigger role in the listed equity market, and there are fewer case studies. He has only analysed a dozen transition stories in the same way. While that is not a representative sample, the stock price drops experienced by those companies is consistent with what he found in Greater China.

Today, just as the A-share market is on the cusp of opening to foreign investors, the first generation of entrepreneurs is entering the early stages of retirement. Fan said there are around 600 family-owned listed companies trading on the Shanghai and Shenzhen bourses, and their number is growing fast relative to the state-owned sector. (There are 1,601 companies listed in Shenzhen and 979 in Shanghai.)

As more foreign investors add A shares to their portfolios, they will encounter a growing number of transition scenarios – most of which are likely to be detrimental to performance. Sifting through the intangibles around family, management, board structures and revenue attribution are important for active investors in any market, but this is going to be especially true of China.

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