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China, today

A cautionary tale of corporate governance pitfalls

12 September 2019
Author: Wenchang MaPortfolio Manager
  • A recent case highlights the potential corporate governance pitfalls when investing in the A-share market.
  • Warning signs are often identifiable before the effects materialise and an active investment approach can help evaluate opportunities, while also aiming to avoid corporate governance pitfalls.
  • As corporate governance in China improves and the A-share market opens up, there is a growing pool of potential opportunities for investors.
  • From our extensive experience investing in China, we believe investors can mitigate corporate governance risks, while also capturing alpha using a riskaware approach to construct a portfolio with sufficient diversification and reasonable valuations.

A fall from grace

Pharmaceutical manufacturer Kangmei Pharma listed on the Shanghai Stock Exchange on the 29th April 2019, publishing its 2018 and first quarter of 2019 results. At the same time, the company announced the correction of prior 'accounting errors', which revised its 2017 year-end cash balance down by an eye-watering RMB29.9 billion (around US$4.4 billion), around 87% of the originally reported RMB34.2 billion. The company claimed it made mistakes in the accounting recognition of both revenue and costs. Positive cashflow from operations in 2017 was restated to negative. The stock opened 10% lower the next day, the maximum allowed under the A-share daily trading volatility limit.

Kangmei Pharma’s market cap has shrunk by over 60% from RMB52 billion (around US$7.5 billion) before the announcement to RMB15 billion (circa US$2.2 billion)1. The company has applied to the Shanghai Stock Exchange to be marked as ‘special treatment’ (‘ST’), which reduces the daily trading price volatility limit to +/- 5%. It has also been removed from the Shanghai-Hong Kong Stock Connect eligible list, forcing passive investment outflows by domestic mutual funds and foreign investors.

The warning signs

Signs of Kangmei’s multi-billion-dollar iceberg could be traced long before the April 2019 announcement. It simultaneously had high levels of both cash and debt (Figure 1) and its controlling shareholder had pledged (borrowed against owned shares) over 95% of the shares owned. However, the market did not react to this until October 2018 when a local media outlet voiced its suspicions. In response, the company released an ambiguous announcement, but at the end of the year Kangmei received notice from the China Securities Regulatory Commission (CSRC) that it was launching an investigation into the company’s information disclosure. Prior to its downfall, Kangmei was considered one of the most successful pharmaceutical companies on the A-share market. At its peak in 2018, shares used to trade more than seven times higher than their current valuation (Figure 1).

Figure 1: Kangmei’s share price

Source: Bloomberg, as at 15.08.19.

Be cognisant of corporate governance risks

What led to Kangmei’s overstatement of RMB29.9 billion in cash remains to be seen. Both the company and its auditor are under investigation. Local accounting experts have several theories, but it may take longer for clarification to emerge. Kangmei’s evaporated cash is an example of a range of corporate governance risks that investors need to be vigilant on.

Another high-profile accounting scandal emerged this year relating to materials company Kangde Xin that dragged Ruihua Certified Public Accountants, one of the largest accounting firms in China, into regulatory investigation. This led to the suspension of IPOs for a number of its corporate clients. The incident serves as a reminder to investors who are new to the A-share market on the importance of due diligence.

Private companies and state-owned enterprises (SOEs) in China often pose risks of misalignment of minority and majority shareholders, while there is high ownership concentration. The founders may have stakes in many businesses and pledge some of their holdings in the listed entities to fund other investments, creating ‘zombie’ owners and potential control risks. There may also be complex and well-hidden related party transactions (where the company or its subsidiaries transact with persons or entities with whom it has direct or indirect interest) that can help inflate earnings and divert cash flow to particular uses. Moreover, independent shareholders’ influence on board decisions is usually very limited. Although SOEs have lower risks of outright accounting fraud, there is the risk of non-transparent control, with some SOEs operating through opaque holding entities.

While there are compelling opportunities to capture alpha on the A-share market, it is important to take into account corporate governance when assessing the risks versus the returns. This is why an active approach to investing in A-shares helps to perform adequate due diligence.

An active approach to investing in A-shares helps to perform adequate due diligence

Further development on the horizon for the A-share market

The current A-share market structure and regulatory framework are partly responsible for the corporate governance potholes. Retail investors play a dominant role, accounting for close to 80% of total market transactions (Figure 3), meaning the short-term momentum-driven focus of such investment often leaves governance malpractice unchecked. For companies that have had corporate governance incidents, there lacks effective punishment, especially on holding key individuals responsible. The cost of bad behaviour, therefore, is not significant enough to offset the potential gain.

Figure 2: Retail investors still account for the majority of A-share market transactions

Source: Shanghai Stock Exchange, China International Capital Corporation, 31.12.17

However, there are signs that this is changing with the regulator pursuing more cases, leading to more fines and greater prosecution of individuals. In 2018, the China Securities Regulatory Commission (CSRC) prosecuted 38% more cases than the previous year, equating to 310 capital market misconduct cases (including information disclosure issues, insider trading and failure of duty as advisers), with a total fine of RMB10.6 billion (US$1.5 billion), up by 42%. It also suspended 50 individuals’ market access (nearly a 14% year-on-year increase). To give some context through a comparison to the world’s largest equity market, the US Securities and Exchange Commission (SEC) prosecuted 821 cases in 2018 with over 500 individuals held accountable and US$3.9 billion issued in fines. Under the current Chinese criminal law, the maximum jail sentence for providing fraudulent information during a stock listing is five years, while it is three years for issuing fraudulent financial reports. De-listing is rarely implemented (Figure 3), while short-selling on the A-share market is still very difficult and shareholder activism is not prevalent.

Figure 3: Delisting has been rarely implemented in China
Number of stocks delisted from the US and China A-share markets

Source: World Federation Exchange, Wind, Morgan Stanley Research, 31.12.18.

However, there are indications that corporate governance is improving in China alongside the A-share market opening up, which is expected to attract more foreign and domestic institutional investors (Figure 4). As the A-share market becomes more institutionalised, this should benefit the market, particularly as institutional investors are becoming more active at giving feedback to companies and the regulators. An example is the active advocacy by the Asian Corporate Governance Association (ACGA), which consists of 113 members across the world, including ourselves. In 2018, China revised its corporate governance code to establish ESG requirements, restrict the power of controlling shareholders, encourage board diversity and accountability and promote the role of institutional investors as stewards in oversight and exercising voting rights. This was the first revision of the code since 2002. Alongside the regulator, stock exchanges are also promoting better governance to nurture a healthier capital market to attract long-term investors and quality companies. For example, the recently launched Science and Technology Innovation Board, or the ‘STAR’ board, on the Shanghai Stock Exchange has incorporated clearer and stricter delisting rules compared to the other mainland A-share boards.

Figure 4: Institutional investors increasingly participate on the A-share market
Investor structure (% of A-share market cap)

Mutual funds include special accounts and exclude accounts of insurers, social security funds and annuities. Trust investment does not include investment by privately offered funds through trusts. Brokers include proprietary trading and active asset management.
Source: Corporate fillings, SSE, Asset Management Association of China, CBIRC, National Council for Social Security Fund, Securities Association of China, Ministry of Human Resources and Social Security, PBoC, CSRC, Wind Info, CICC Strategy Research, 31.12.18.

A closer look at the fundamentals

When analysing A-share companies, there are some red flags (Figure 6) that we at 4Factor look out for. However, this is only a summary of some common red flags. In practice, problems could be hidden within complex related-party transactions and accounting manipulation and are therefore more difficult to detect. This is why we stay focused on learning from the broader market experience and case studies to keep enhancing our analysis skills. Conversely, Figure 7 explains some examples we consider to be good corporate governance practice.

Figure 5: Red flags in corporate governance

ACCOUNTING POLICIES AND CORPORATE BEHAVIOUR CORPORATE STRUCTURE
Abnormally high revenue growth or margins compared to peers Unnecessarily complex corporate structure
High levels of cash and debt; low interest income, but high interest expenses Appointment of broader family members on the board or in key management roles
Unusual working capital movement (low receivables or inventory turnover; significant increase in receivables or inventories; lower than average bad debt provisioning or inventory impairment policies) Large owner or key executives have significant % of stakes pledged or record of suspicious stock transactions
Mismatch between profit growth and cashflow Management has past track record of being related to personal or professional scandals
Frequent M&A and significant goodwill as % of assets Frequent change of management, especially the chief financial officer
Heavily dependent on related-party transactions Using auditors who were responsible for previous responsibility failures
Frequent restructuring and capital raising, especially issuing shares at very low valuation
Change of accounting policies

 

Figure 6: Green flags in corporate governance

ACCOUNTING POLICIES AND CORPORATE BEHAVIOUR CORPORATE STRUCTURE
Consistent and conservative accounting policy Straightforward corporate structure with very few layers
Rational expansion plans; improving returns by giving cash back to investors when there are no major expansion projects Stable and motivated management, whose interest is aligned with minority shareholders through key performance indicators and share incentives
Regular voluntary disclosure of operational metrics that help investors understand the business development For private companies where the founder or large shareholder is the key manager, ideally the stakeholder should be focused on the business with limited or no other business interest outside of the core entity
Management is willing to communicate with investors and provides clear and consistent messages about the business strategy and the execution Good quality Board of Directors, with more than a third of the members being independent with relevant skill sets to the company business and hold as few positions in other companies as possible

 

Navigating the corporate governance pitfalls

There is no systematic way to avoid the numerous corporate governance pitfalls without withdrawing completely from the attractive opportunities on the A-share market. Third-party data providers have been working on increasing coverage and rating stocks, but there is a lack of consensus on measurement, while data availability and consistency remain hurdles for a quantitative rating that can be easily interpreted by investors. But simply deciding not to participate in the world’s second largest equity market in itself is posing increasing opportunity cost, particularly as A-shares are set to make up a bigger part of major global indices, such as MSCI and FTSE Russell. After all, Chinese equities offer an expansive opportunity set with a myriad of abundant and diversified growth drivers, as well as reasonable valuations to unearth.

Given China’s strategic importance, attractive long-term growth potential, increasing index inclusion and diversification benefits, it is rapidly becoming one of the biggest decisions that asset allocators must make, as discussed in a recent paper. It is not possible to definitively summarise all the corporate governance pitfalls and how to avoid them in a few paragraphs, particularly with the nuances that exist at a company-level. However, we believe the following high-level guidelines should help investors mitigate the risks:

  1. Take an active approach. Understanding the rationale behind typical ‘book-cooking’ measures and how they are likely to reflect on the financial statements is a crucial skill. Cross comparison against companies in the same or similar businesses is also helpful in identifying abnormalities. Beyond financial statement analysis, keeping a close eye on social media can often be helpful to identifying traces of bad governance. Supplementing desk-based research with the traditional way of gathering information and analysis is an effective way to navigate the market, which requires knowledge of the local market and language skills. This means on-the-ground visits to the companies themselves, alongside the associated upstream and downstream businesses within their supply chain, to gather an indication of the soundness of their operations. In our view, thorough bottom-up fundamental analysis is the best route to protecting asset values
  2. Access differentiated and diversified sources of return. China is a dynamic market and there are close to 3,000 A-shares to choose from, with diversified business models and growth drivers. This offers the opportunity to build a concentrated portfolio while at the same time diversify the risk exposures at a portfolio level.
  3. Capture reasonable valuations. A valuation safety margin, which can absorb a share price fall, provides the last buffer for potential governance risks. Investing in stocks that are reasonably valued also factors in the balance between risk and return. The risk and potential impact of corporate governance incidents tends to be significant, and therefore limiting losses becomes all-the-more important.

The China A-share market offers abundant growth and opportunities to capture alpha and its importance to global asset allocation is on the rise. But the emerging nature of this market also means it is still a minefield of corporate governance risks. However, there are signs that corporate governance is improving, while a positive feedback loop is underway as more institutional investors participate and ask more questions. For bottom-up stock pickers, this presents an opportunity to actively manage ESG risk and select legitimate companies with sustainable business models that stand out from the crowd. For investors who are willing to take measured risks to reap the benefits of this compelling growth market, we believe the best route is through diligent bottom-up fundamental stock selection, using a risk-aware approach to construct a portfolio with sufficient diversification and reasonable valuations.

1Source: Bloomberg, 15.08.19.

 

General risks: The value of investments, and any income generated from them, can fall as well as rise. Past performance is not a reliable indicator of future results.

Specific risks: Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income.
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.

Wenchang Ma
Wenchang Ma Portfolio Manager

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