China’s A share market is large, deep, volatile and dominated by retail investors, of which some 7% are rumoured to be illiterate. Capitalized at US$9 trillion, it contains many companies that are severely overvalued, inefficiently run, and that spare little thought for minority investors. While many have no investor relations contacts or even websites, a great number also have no member of senior management that speaks a foreign language, which makes communication with foreign investors near impossible. Gary Greenberg, Head of Emerging Markets at Hermes Investment Management asks, should such a market become part of a benchmark for global investors?
At a US$9 trillion market capitalization, Chinese A shares should not be ignored, but clearly governance standards have to rise. However, China is in many ways a world unto itself. Most of China’s corporate, provincial, and national debt is owed to itself, and much of China A shares’ equity is owned by Chinese entities, often a municipality or a province. In fact, the most influential person in management in a Chinese company may not be part of the management at all: he (usually a “he”) is a representative of the Chinese Communist Party. As a result, conflicting loyalties are very much a factor, under the surface.
China has always been a communal society, where clan and regional loyalties play a large part in the social ethos, in stark contrast to the individualism (be it rugged or refined) embraced in the West. Communal loyalties are especially strong when a company is majority owned by the city or province in which it is situated, and employs tens of thousands of people in the area. While there are a few truly national and international Chinese A share companies (the large insurers, banks, and some manufacturers like Gree, Midea, and Shanghai Automotive), the vast majority are regional players, with strong home roots.
Listing has been seen as a way to raise capital while retaining hometown control. In many emerging markets, raising equity is often viewed as a cheap way to add capital, “costing” only the dividend, and dividend pay-outs have been notably minimal. However, regulators in China are on the case: many that do not pay dividends are referred to by the chair of the local regulator, the China Securities Regulatory Commission (CSRC) as ‘iron cockerels’, a Chinese idiom for cheap-skates. Thus, outside shareholders are sometimes seen as a necessary but somewhat annoying distraction from management’s day job which consists of keeping the Party Secretary happy, providing local employment, and, if possible, finding a way to get rich.
Management getting rich is of course an acceptable goal in the capitalist system, which has evolved in such a way as to facilitate this, as long as it happens alongside the outside investors, and in a proportional manner. Here is where management education comes to the fore, but also where it is lacking. Hermes, through our EOS engagement team, along with other concerned investors, work with policy makers, company boards, and regulators to share best practice and encourage its adoption. China is still at the early stages of learning best practice in governance, but our past successful engagement experience on this topic in other markets should help to accelerate the process.
Risk is high in the Chinese A share market, but potential returns are also substantial. The market’s immaturity and inefficiency provide ample opportunity for careful stock pickers to identify undervalued franchises which could turn into tomorrow’s multinationals. Furthermore, engagement provides insight into the cultural evolution of a company as it grows. In a balanced portfolio, therefore, there is a place for Chinese A shares; as governance improves, that place should expand.