To this end, our Investment Institute’s 2015 Journal explored the evolution of China’s capital markets. We also publish a quarterly China Indicator. In the most recent issue our Emerging Market Fixed Income and 4Factor Equity teams examine three main indicators of the progress of China’s economy.
The Chinese government continues to announce reforms of its state-owned enterprise (SOE) sector, every few years it seems. The most recent official line was articulated in a commentary published on China’s official newswires service, Xinhua: “Reform is the only way forward for China’s economy… for there is no plan B.” Figure 1 graphically illustrates the issues the government hopes to address. Leveraging and overcapacity have been climbing for twenty years, while profits and returns have eroded. The case for reform has never been more stark.
Figure 1: China: A tale of two economies - Old/new economy sectors saw divergence in ROE
Source: Wind, CICC Research
The question for investors, however, is how realistic are the announced reforms and how much real action can we expect? Beijing remains wary of attacking excess capacity head on by shutting uneconomic enterprises due to the potential economic and social impact, however, we think that a carefully selective and active approach can unearth worthwhile investment opportunities. But investors need to remain highly selective and stay on their toes, as things can change rapidly in China and a promising opportunity one day can disappear the next.
The coal industry provides an example of how SOEs can be reformed, and what it takes to do so successfully. First off it takes a decent management team that are motivated to change, along with government will to reform. Coal industry and government policy has reaffirmed a commitment to capacity closure, and output growth has been edging lower. Despite this, the sector as a whole is still awash with overcapacity and zombie companies.
Figure 2: China monthly raw coal output and YOY growth
Source: CLSA, NBS
The shining light in the industry is China Shenhua Energy Company, which has a relatively good team in place and the results demonstrate that reform is possible. It has a solid balance sheet and has been carefully and selectively cutting costs and capital expenditure over the last two years. As a result of management initiatives, the company has substantial free cashflow, while its peers are haemorrhaging cash.
The consolidation of the steel industry – a sector that exemplified China’s overcapacity issue – is underway. Consolidation appears positive at first glance, and recent government proclamations certainly sound constructive. But it requires meaningful ownership and management reform or it risks combining inefficient companies that continue as before rather than making meaningful change. In some cases, a well-managed profitable company can be encouraged to merge with an unprofitable, poorly managed one.
Figure 3: China steel product vs. YOY
Source: CEIC, Wind
For example, Shanghai Baosteel Group Corporation and Wuhan Iron and Steel (Group) Corporation are being merged to become the world’s second-largest steelmaker. Baosteel has been a shining light in an industry of great overcapacity and weak demand. It has managed to maintain profitability due to its focus on the growing autosheet sector. Strikingly, in 2013, Baosteel with roughly 4% of total steel capacity in China accounted for 35% of the industry’s profit. Wuhan is rather less effective as a company and it remains to be seen whether Baosteel can turn it around.
We remain highly selective when considering SOEs, but there are opportunities out there. The key to success is selecting companies with robust and skilled management teams that are investor friendly and highly incentivised to deliver positive returns. Finding them requires robust expertise on the ground in China, actively selecting and evaluating companies daily.
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