China’s equity market may be back from the dead, but it is still in dire need of surgery.
In theory the country’s stocks should be thriving, courtesy of operating in an economy that is both the world’s second-largest and one of the fastest-growing. China has long boasted strong manufacturing, export and economic fundamentals – just the sort of factors that should encourage a bull market.
Instead its stock markets have been among the world’s worst-performing in recent years.
Between 2007 and the end of 2012 the Shanghai Stock Exchange Composite Index experienced an unprecedented collapse in value, falling from an all-time high of 6,124.044 on October 16, 2007 to 2,269.128 on February 18, 2013. That’s a reduction of nearly two-thirds in less than five and a half years.
In a survey conducted by China’s Southwestern University of Finance and Economics in May, 77% of nearly 8,500 households admitted to suffering stock-market losses. The survey concluded that equities had been the worst-performing asset class over five years.
Yet over the past few months this negative situation has turned. In the fourth quarter of 2012, news that domestic retail sales and infrastructure spending were on the mend prompted the Shanghai index to leap from 1,959.77 on December 3 – the lowest level since January 2009 – to 2,421.56 on February 18; a jump of 23.5%.
The rally encouraged many retail investors that the stock market is on the way up. They are beginning to put money to work once more, hoping that a new administration led by Xi Jinping will introduce greater market reforms and spur infrastructure spending.
But analysts are less confident. They note that China still has questions to answer over how to best address an aging population and maintain long-term growth in an economy still reliant on state investment and exporting.
“This year will probably be pretty weak for equities,” says Laban Yu, equity analyst at Jefferies in Hong Kong. “Equities ended last year pretty strongly in the fourth quarter because industrial activity picked up and people thought it was back to the good old days in terms of investment spending on infrastructure. But in 2013 we’ll start to see a rebalancing of China’s growth model away from infrastructure spending to consumption and services.”
The recent market bounce-back may have pleased investors and the new Communist leadership, but the structural problems that caused five years of poor performance remain. And unless addressed they will hurt market performance again, particularly in a year of policy uncertainty.
Beijing needs to enact major market reform to ensure a genuinely healthy equity market rather than one that enjoys short-lived speculation-based performance. That will require regulatory overhauls and sincere efforts to improve corporate governance.
Such changes won’t be easy or popular with listed companies. But they are necessary if China is to restore credibility to a core form of capital-raising.
Roller-coaster ride
For much of the 2000s China’s equity market surged. But, as with so many other markets, this was brought to an abrupt end by the global financial crisis.
China was less directly exposed to the struggling global financial environment than geographies such as Europe, Japan and the US. Yet in the years since the crisis, its markets have lagged the recovery of these bourses.
Between October 2007 and February 2013 the S&P 500 Index dropped 1%, the Nasdaq Composite rose 14%, and the FTSE 100 Index slipped 5%. The Dow Jones Industrial Average has fully recouped its losses, closing at an historical high of 14,253.77 on March 5, beating its previous high of 14,164.53 on October 12, 2007.
Only the Nikkei-225 Index was anywhere near as weak as the Shanghai index, dropping 33.5% due to Japan’s struggles to climb out of recession.
Yet this long-term poor performance is swiftly being overlooked as, since December, Chinese stocks have begun rising along with those across the world. This newfound optimism is largely down to decent corporate earnings and, more importantly, high expectations for the country’s new political masters.
Rallies such as this demonstrate one key flaw in China’s stock market. As things stand, the most important factor supporting stock investments in China is politics, not performance.
More than 50% of the country’s equity market comprises state-owned enterprises’ (SOEs) stocks. Beijing has prioritised their success, especially since the global financial crisis of 2008-2009. Designated as the nation’s engines of growth, the SOEs have received trillions of renminbi in cheap loans to serve as fuel.
The focus on growing the economy largely via these state companies has impacted investing trends. Investors focus heavily on sectors the government appears keenest to promote, presuming that the SOEs in these areas will receive support and subsidies.
“Listing on the A-share market is a very political move,” says Junheng Li, head of research at JL Warren Capital, an equities research firm. “There’s a lot of political loyalty and government interference, and there’s a lack of protection to creditors and a lot of favouritism to state-backed issuers. For SMEs [small-to-medium-size enterprises], if something goes wrong then no one will help them. It’s often an unfair system.”
She notes that financial companies, telecommunications firms and energy producers (most of which are state-affiliated) account for approximately 35%, 13% and 17% of the MSCI China Index, despite comprising less than 13%, 3% and 6% of China’s gross domestic product (GDP), respectively. Yet while consumer goods companies comprise more than 21% of China’s growth, they represent less than 6% of the index.
With so much of the market made up of state-backed entities – companies that can’t be called truly public– investors’ opinions matter relatively little.
Much of the SOE earnings are reinvested into company management – often Communist Party insiders – and the SOEs do not exclusively use earnings to grow their businesses, or at least not in core areas. And their lack of operational transparency makes for an opaque understanding of fund flows.
Neither do they do a particularly good job of making money.
“State-owned enterprises account for 39% of total listed companies on the A-share market, but 51.4% of the market capitalisation,” Jing Ulrich, chairman of Global Markets, China, at J.P. Morgan, tells Asiamoney. “SOE profits declined by 6.9% year over year in 2012, compared to an average 5.2% increase in industrial profits, so it is fair to say that the financial performance of SOEs did not boost market performance last year.”
Dearth of dividends
The dominance of SOEs on the stock exchange, which are beholden to nobody but government, has stymied the development of an active investor community. It has also reduced any expectation of dividend payments.
According to market regulator the China Securities Regulatory Commission (CSRC), 39% of mainland-listed companies did not pay shareholder dividends in 2010. And those that did only offered a respective 41.69%, 35.85% and 30.09% of net profits in 2008, 2009 and 2010.
By contrast, the percentage of earnings paid to shareholders as dividends has fluctuated from 40% to 75% for Europe ex-UK companies in the past decade, according to Société Générale. And the average dividend payout for mature and established industrial firms in the US is 50%-60%.
“Traditionally China is much more about stock prices going up rather than paying dividends. You’re really in there for a rise in the market value more than a dividends payout,” says Jelle Vervoorn, managing director at HFT Investment Management, which invests into China through a renminbi qualified foreign institutional investor (RQFII) licence.
A stronger emphasis on dividend payments would force Chinese companies to be more accountable to shareholders. Investors who expect to receive money would be rightly upset if it didn’t arrive, and consequently more interested in knowing how companies are run.
The Shanghai Stock Exchange (SSE) appears to agree. On January 8, it encouraged listed Chinese companies to pay at least 30% of annual profits to shareholders as dividends.
It’s a step in the right direction, but it doesn’t go far enough. The 30% floor is merely a suggestion, and the bourse has not outlined punishments for companies that do not pay up. China should follow some European nations in mandating that listed companies pay at least 40% of earnings towards dividends. This would help lift company performance and incentivise investors to seek quality shares.
Post-listing blues
There is a compelling reason that investors should receive better dividends from companies whose stocks they buy: it holds businesses to account.
Under current conditions the average efficiency of Chinese companies falls markedly once they have gone public. According to JL Warren Capital, the operating performance of listed firms as measured by return on assets (ROA) and return on sales (ROS) deteriorates considerably after public listing.
The ROA drops from an average of 15.3% before listing to 5.7% afterwards, a fall of almost two-thirds. The average ROS after listing almost halves, from 19% to 10%.
The drop in performance is partly because the goal of many business owners is to build a company to the point that it can list. Once owners have had their payday, they are less motivated to maintain standards.
It doesn’t help that these companies have not historically received much heat from the CSRC to live up to corporate-governance standards, while investors lack the mettle to hold them to account for sliding standards.
Forcing listed companies to raise dividend payments would help prevent such indolence. Investors who receive annual payouts will begin to rely on them in addition to share-price performance to earn money. That would make them interested in ensuring that the companies into which they invest perform and pay out, or in finding other businesses that do better. And as part of that decision-making process, they are likely to demand more information as to how businesses are run.
Private companies are unused to shareholder activism, yet unlike their larger state-owned peers they lack alternative funding via cheap public funds. Given shareholder ultimatums to either improve or see their values fall, they would feel pressure to perform.
It’s also vital to place more pressure on companies to commit to good corporate governance. Several misfiring overseas-listed Chinese companies have been caught out trying to hide balance-sheet weaknesses in recent years, damaging the credibility of others in the eyes of international investors and raising questions about local corporate-governance standards.
Fortunately other Chinese companies operating abroad have thrived (see box), offering examples of the benefits fiercer corporate standards can bring. Plus the CSRC has been more aggressive of late in its efforts to implement tougher reporting standards and investor protection oversight.
“Over the past year, the securities regulator has initiated a wave of reforms to put the A-share market on a more conventional course of development, with stronger investor protections,” says Ulrich. “To balance the investing function of the market relative to its financing function, the CSRC has cut trading fees and introduced a series of measures to improve disclosure, push companies to increase dividends, contain excessively high IPO prices and expand delisting criteria. These reforms are positive steps towards restoring market confidence.”
Ultimately, responsibly run private businesses that take shareholders seriously are more likely to succeed, be rewarded by investors, and raise further funding in the equity markets.
That could be a key advantage given Beijing’s plans. The government has indicated it is in favour of more private investment entering state-dominated industries, such as railroads, utilities, transportation, oil and gas, in an effort to boost efficiency. Just as similar political winds have sent investors to SOEs in the past, privately owned enterprises may be in for more attention.
These capital-intensive businesses will require sizeable funding. Companies most likely to be able to raise such funding will be those that can demonstrate they are well-managed and responsible.
Reactive retail
Forcing listed companies to better respect investors and corporate governance is just half the battle. China’s government also needs to promote a healthier investor base.
Approximately 80% of Chinese equities are held by mom-and-pop investors with few investing alternatives. That compares to just 25% in the US, 20% in Tokyo and 30% in Hong Kong.
Retail investors tend to follow market trends more than their institutional peers, and they flip investments faster. Approximately 70% of local investors hold stocks for less than six months, making them among the fastest flippers in the world and the SSE the fourth-busiest by trade volume, despite being the world’s sixth-largest exchange.
“Often retail investors have a shorter-term view of the market than professional investors, which tend to hold on to their stocks for longer,” says Caroline Keen, investment manager for Asia Pacific ex Japan equities from Newton, part of BNY Mellon. “Retail investors can be prone to panic and selling out at the bottom, therefore missing out on the upside of the recovery cycle. And they tend to re-invest when equities have already rebounded.”
This fickleness has helped damage the performance of new listings. Of the 154 companies that listed in 2012, 64 were trading below their IPO price as of February 21, according to data provider CapitalVue.
“It has always been in the minds of particularly retail investors that as long as you buy into an IPO, you will earn money,” says Fang Jian, Linklaters’ national managing partner in China. “It is still one of the factors that drives up IPO prices...but then value drops immediately when investors sell quickly – a lot of investors won’t even look at the prospectus before they buy.”
All in all it has led equities to be a bad investment. J.P. Morgan estimates that a retail investor who put Rmb100 into the CSI 300 five years ago would have seen their investment drop to Rmb47 by December 2012. This compares to Rmb197 if they placed their money into gold.
Invitation to institutional investors
The best remedy is to raise the participation of institutional investors in the market.
Institutional investors are paid to invest, giving them a more educated, longer-term perspective. They also tend to take corporate governance and shareholder rights seriously and like to receive dividends.
Their participation would be good for market development, but raising it will be difficult. Banks, mutual funds, pensions and insurers have been most active in the bond market in recent years, as the instruments provide guaranteed returns and offer more reliable growth. Property and commodities have also been favoured investments.
One way companies could seek more institutional money would be to give such institutions special buy-in opportunities ahead of new fund-raising. Additionally, regulators could impose lockup periods so retail investors do not sell shares too quickly, lessening market volatility and potentially making investments more appealing for institutional managers.
But professional fund managers are unlikely to seriously put money back to work in local equities until secondary-market performance increases. This will take time.
There is one way for China to quickly add institutional-investor liquidity into its local markets –throwing the doors open to foreign institutional investors.
Currently foreign fund managers require a qualified foreign institutional investor (QFII) and renminbi foreign institutional investor licence to access the A-share market. As of February, there were 207 QFII licence-holders allowed to invest US$37.44 billion, and 89% of this went to onshore equities, according to the CSRC. RQFII holders meanwhile have Rmb70 billion in assets, mostly invested into bonds due to regulation, but the CSRC is poised to expand the total by another Rmb200 billion and eliminate the cap.
These reforms position China for inclusion in global indices. The FTSE’s CEO predicts that limited restrictions on foreign investment means A-shares will comprise 3.1% of the FTSE Global index within five years. This automatically gives institutional investors who track the index greater A-share exposure.
These foreign investors are confident that their experience and savvy helps them buck the trend of poor-performing A-shares to see profit.
“Detecting fraud can be very, very difficult – if it were easy it wouldn’t happen so often,” says Diederik Werdmölder, CEO at SinoPac Asset Management. “What you really need to do is go beyond desk research to study the financials of a company you’re looking to invest in and speak to the managers, customers and suppliers, and kick the tyres. We invest in areas that we think can grow. You have to do your homework to take a longer-term view of the macro story.”
In 2012, QFII funds had better luck in the A-share market than their onshore peers, albeit by a small margin: international institutional investors saw an average 7.43% return on their investments while Chinese equities funds registered a 5.99% return, according to research firm Lipper.
The offshore investor quotas have been rising, but they still only comprise 1% of China’s equities market. CLSA analysts predict this can expand to 10% within a few years, but even then the influence of such investors will be minimal in the greater scheme of the market.
Nevertheless, this limited influence will help pressure mainland companies to disclose financial materials, adopt good governance procedures and pay dividends. Local retail investors would learn from these institutions, and benefit as listed companies comply with the demands of more experienced accounts. And companies that respond to professional fund managers would benefit from more support.
No easy solution
China has long-term aspirations that its stock markets will function just as more mature global bourses, but the CSRC has a long way to go before this is accomplished.
The market is held back by an inadequate approvals process for IPOs and insufficient corporate-governance standards post-listing. Other factors are the economic dominance of government-backed companies that have almost no incentive to listen to investors, private companies facing insufficient pressure to improve post-listing performance, and the tendency of retail-dominated investors to base investments on political rather than financial fundamentals.
This combination serves to more than offset China’s robust economic fundamentals when it comes to market performance.
There is no silver bullet to cure these ills. But a good start would be to foster better-educated investors and more responsible private companies. This means encouraging investors who understand the importance of due diligence and accurate corporate information, and know how to spot companies with potential. And it requires companies that understand that cooperating with investors is a strength not a weakness, netting benefits for both sides.
Ultimately, regulations can only do so much. The best way for Beijing to create a vigorous stock market is to let private companies drive economic growth, not unaccountable state behemoths.
In other words, don’t expect the nation’s stock exchange to fully regain its health any time soon.
