‘Pearls don't just lie on the shoreline; you must dive in the ocean to find them.’
Success only comes through greater effort - Chinese proverb
As China transitions from being a ‘participant’ in globalisation into a ‘shaper,’ investors are looking to the region for its exciting opportunities. China’s growth story offers strong potential; but investors can be deterred by risks arising from the differences between Chinese corporate governance compared to more established markets.
To help inform investors about risk in China, Janus Henderson presents this wide-ranging educational series – China investing: Signals and Smokescreens. This is based on an in-depth study of China stocks that underwent periods of intense financial stress in recent years. Based on the outcome of whether the stock price collapsed or survived, the study identifies a set of pre-existing signals and common characteristics that can potentially help global investors understand and identify China-specific risks going forward.
The Chinese growth story at a glance:
- 2228% rise in market capitalisation of the MSCI China since 2000*
- Chinese economy = larger than the US (in purchasing power parity terms)
- Alibaba (Chinese internet stock) = largest IPO in history in 2014
- More than US$30bn losses from China-based reverse takeover frauds in 2011
- 200+ Chinese A share companies joined the MSCI EM Index in June 2018
*Source: Bloomberg, 1/1/2000 to 31/12/2017 in US$ terms
While many Chinese stocks have performed extremely well in the last decade, there have been a number of high profile failures, often associated with governance issues. Understanding the relationships between companies and their stakeholders – particularly the State – is critical in assessing governance-related risks. For global investors, viewing opportunities within the unique context of China is essential, and this study reveals scenarios that would be unlikely in more established markets. Examples include:
- An independent director, who was accused of negligence for failing to detect malfeasance, argued that he should not be punished because he ‘always regarded an independent directorship as an honorary title’, ‘knew nothing about the operation of the company’ and ‘did not have the ability to understand the accounting sheets’.
- A chief financial officer who tendered his resignation after the board had ‘denied him sufficient access to the financial records’.
- A company that made a public announcement on NASDAQ that its chief executive had fired the external auditors half way through the audit because they had asked to see the bank statements, a request that was deemed to be ‘overly broad’.
- A board of directors which, on arriving at the office building in order to retake control over their operations, were water-cannoned by the local Chinese management team.
‘Signals and smokescreens’
Building on its expertise in investing in Chinese companies, and Asian equities generally, Janus Henderson has undertaken the ‘Signals and Smokescreens’ study by analysing publically available information from companies that underwent periods of intense financial stress in recent years. Some of these companies failed while others survived. From this study, certain red flags emerged as indicators of potential risk; and also green flags that could indicate a certain robustness that enables a company to weather the storm.
The purpose of the study is to share knowledge and help global investors gain a better understanding of risk and corporate culture in China. Written in partnership with author Tim Clissold, an expert on business in China, the study explores the Chinese corporate mind-set and ownership structures that help determine whether minority investors in the public markets get their fair share of the fruits of corporate success.
Janus Henderson believes it is imperative to invest with a proper understanding of the risks and implications in all markets and that, in keeping with the proverb above, there are pearls to be found in China, but only through diligent analysis and risk assessment. The study will be released as a series of modules and include insight from our Asian equity investment managers.
Implications for investors
Mike Kerley, Director of Pan-Asian Equities and Portfolio Manager at Janus Henderson Investors:
“China’s development into a key player on the world stage has been dramatic and, for investors, its importance is only going to grow in the years ahead. The difference in how companies are run in China, however, makes it essential to look behind the numbers. There are key differences in board structures, corporate governance, the relationship management has with individual investors and whether companies are acting in shareholders’ best interests. This study seeks to help provide a context for investing in China and provide insight into the risks beyond the numbers.”
Tim Clissold, China author and businessman:
“The business environment in China is still quite young and this has consequences. Its high growth, entrepreneurial companies are often still driven by the founder and these individuals by their nature are often incredibly focused, driven, independent and prepared to take risk. This tends to be coupled with relatively weak governance, with the tradition of having a strong board and external audits still fairly new, and the regulatory framework is also in its infancy compared to the US. This means that there are definitely exciting opportunities but equally there are significant risks that it is essential investors are cognisant of.”