Aberdeen Standard Investments has been investing in Chinese equities since 1992. It has been a journey punctuated by caution and careful consideration during which the asset manager had to overcome significant reservations along the way, contending with government interference across sectors; the inexperience of Chinese entrepreneurs; a legally ambiguous fund structure; and poor corporate governance. Nonetheless they found, and continue to find, good companies to invest in, points out ASI in the first part of its analysis about this market.
Starting point
For almost two decades ASI preferred to invest in Hong Kong-based companies, mostly privately owned firms whose management teams were subject to strict regulatory oversight and demonstrated high standards of governance. Increasingly this included ‘China plays’: businesses which benefitted directly or indirectly from rising prosperity and strong economic growth in mainland China. “This approach afforded us both comfort as an investor and access to strong potential growth”.
State ownership
Backed by rigorous research, frequent company meetings and engagement with managements, ASI gained sufficient comfort to invest in mainland-headquartered companies listed in Hong Kong known as H-shares and red chips. Initially they favored well-run state-owned enterprises (SOEs) exposed to secular growth trends that we considered less susceptible to government policy and interference.
Hong Kong listing requirements ensured their reporting and disclosure standards aligned with international norms. Intuitively, investors may think to avoid SOEs on the assumption that privately run firms have superior execution capabilities and profitability. “But, in practice, some SOEs have sound management teams and operate in high-growth industries where they enjoy ‘protective moats’ against competition”, says the asset manager.
In China’s property sector, for instance, there are a range of SOEs and private companies. ASI invested in one state-owned developer which focuses primarily on first- and second-tier cities. It was one of the first Chinese developers to diversify into shopping malls, where rental payments offer steady and recurring income streams. As an SOE it enjoys one of the lowest borrowing costs in the sector, helping it to maintain one of the healthiest balance sheets.
As such it is better positioned to weather a downturn or consolidate opportunistically. By contrast, we have steered clear of privately owned developers that have excessive leverage, weak balance sheets and extensive investments in non-core assets.
Structural integrity
Over the past decade there has been an explosive growth of China’s internet sector in segments such as gaming and e-commerce, which presented promising new opportunities to invest in growth stocks listed in Hong Kong and the US. But, assures ASI, it came with a snag: “direct foreign ownership is restricted by law because China treats its internet technology sector as sensitive”.
As a result, many of these companies were structured as Variable Interest Entities (VIEs), which consists in a contractual agreement with the company’s domestic entity designed to circumvent domestic laws on foreign ownership. “We viewed it as a risky legal structure from a shareholder’s point of view. Licences, and in some cases operating assets, are held by a VIE rather than by the listed entity. They also offer weighted voting rights, which we are not in favour of”.
After a huge amount of due diligence on the structure over many years, ASI concluded that the government was unlikely to declare VIE structures illegal or impose disruptive changes that would be negatively perceived by global investors. Already VIEs had become such an integral part of the domestic stock market and economic activity.
“Moreover, we discovered that not all VIEs were the same. Some were friendlier to minority shareholders than others. At the same time, relative comfort with one VIE structure does not equate to comfort with all of them”, notes the asset manager. But by taking account of the ownership structure, country of incorporation and listing, voting structure and person in charge, we felt able to discern quality among VIEs.
In 2017 ASI invested in a Chinese internet technology company that, while it operated as a VIE, it had a one-share, one-vote structure. Over time they grew more comfortable with its management team, plus it was listed in Hong Kong, which historically has provided strong regulatory safeguards for minority shareholders. “In the end we felt confident enough to invest .Of course, we continue to monitor the regulatory environment closely. But our familiarisation with the VIE structure offers a salient example of the need for adaptability in this market”.
In the second and final instalment of this series, ASI will explore the evolution of our investment into Chinese A-shares, from its earliest steps to today, in conjunction with the market’s increasing accessibility and incremental improvements in corporate governance.
Por Funds Society, Madrid