Which Chinese businesses are better for investors?

Consider private versus state-owned and related party transactions

China, the world's factory and second largest economy, is only gradually being opened to foreign investors. The transition from centrally planned economy to a market-based system has seen Chinese state monopoly businesses floated in public share listings on the stock exchange, but with the state more or less maintaining a controlling interest. This is unlike the rest of East Asia where firms are in the hands of private individuals or families.

Peculiarly, Chinese public companies have had to remain profitable to maintain their listing on the stock exchanges, which invited related party transactions to prop up ailing businesses.

The privatisation process during the past 15 years in the fiercely competitive Chinese market has seen the survival of the fittest – and some not so fit, but still alive, thanks to subsidies from their state (central, local or bureaucratic) owned enterprise parents.

So foreign investors have to work out which businesses are focused on making money for shareholders, and which are focused elsewhere, perhaps funnelling – or 'tunnelling' – profits off to parent state companies or being propped up for political ends.

It can be a two-way street, with state-owned parent companies helping their 'independent' offspring with cheap loans, for example – advantages not available to private or family owned companies.  For investors, the question hanging over such related party transactions is how they affect a company's bottom line and dividends in the long run.

Relative performance

To answer this question, researchers at UNSW Business School investigated 45 state-owned enterprises and 45 private companies, to see whether such related party transactions add to or subtract from their performance, as measured by return on assets.

The surveyed companies were publicly listed on stock exchanges in China between 2007 and 2009 and had adopted the 2007 Chinese accounting standards that disclosed related party transactions.

Research co-authors Leon Wong, a lecturer in the school of accounting at UNSW Business School, and Yezhen Wan from KPMG, found that state-owned enterprises outperformed privately controlled firms by almost 4.5% in terms of returns on assets.

Yet this was offset by state firms tunnelling away about 6% of returns, so they under-performed privately controlled firms by a net 1.5% of returns on assets. The researchers' modelling did not find evidence that private firms engaged in propping up or tunnelling.

According to Wong, the study helps to disentangle some of the factors in determining the relative performance of private and state-owned companies listed on China's stock exchanges.

'State-owned enterprises take advantage of [their] outperformance by tunnelling much of those gains out from listed firms to the parent firm'


Special characteristics

In the argument about whether private or state firms in China are better performers, the conclusions of previous research papers have been divided. But there have been two prominent factors in explaining performance by Chinese companies – whether they are state or private controlled and whether money flows out in related party transactions.

"Our paper attempted to explain that the mixed evidence was due to the research not disentangling the relative impact of state versus private ownership and related party transactions, but once such transactions were included in the analysis, the evidence was clearer," Wong says.

"It might be useful for investors to know that, generally, state-owned enterprises outperform private firms but only because of explicit or implicit state support from subsidies, quasi-monopolies, access to cheap credit from state-owned banks, [or] implied guarantees of their debt from the state.

"However, state-owned enterprises take advantage of this outperformance by tunnelling much of those gains out from listed firms to the parent firm, attenuating this outperformance. Indeed, the key contribution of our paper was being able to ascribe the relative performance to those two factors."

The research is timely as China takes another step to opening its stock markets to foreign investors through the inclusion of Chinese A shares in the MSCI emerging market index from next year.

It is a small start, but China is moving cautiously in opening capital markets for fear of losing control over its currency, which is gradually being floated. For their part, international investors are cautious about how transparent Chinese company dealings are, as well as lack of access to the market, liquidity in a crisis and government meddling.

Yet international investment funds that follow the MSCI are expected to put an initial estimated $30 billion into Chinese stock exchange listed companies, or about 1% of emerging markets' companies.

"Our paper suggests that investors should take into account the special characteristics of the Chinese stock market which, among other things, are that the ownership nature and existence of related party transactions skew the expected performance of such firms," says Wong.

'Companies with strong cash flows do not always invest them efficiently'


Transitioning economy

It is an issue familiar to Australian managed investment company Platinum's Asia Fund portfolio manager Joseph Lai, a medical doctor who switched careers to graduate with an MBA from UNSW Business School.

Lai searches China for businesses with longer-term growth prospects that will do well as the economy transitions into a consumer oriented one. His fund has invested in internet and telecommunication companies, gas utilities, insurance, prestige liquor and dominant sporting goods brands. Lai is on the lookout for any prospective company's related party transactions.

"I guess tunnelling or funnelling money to the parent company or its subsidiaries happens everywhere when state-owned enterprises are privatised," he says. "Even in companies [such as] Telstra, which funds investments outside its area of expertise.

"It depends on the type of company. There are many different types of state-owned enterprises in China, some are still quasi-monopolies even though they are listed on the stock market.

"There can be a conflict between state control versus maximising shareholder returns. State-controlled companies can be profitable but private companies are about profit maximisation. Monopolies do not always have that incentive. They can be – if they have good corporate governance and strong rewards for staff to incentivise them."

Real aims and goals

Lai notes that state monopolies can benefit from preferential terms and subsidies from government.

"But investors ask: what are the real aims and goals of their companies? Are they about dividend returns for shareholders or some other ends, such as employment for local people? Some Chinese state-owned enterprises were transformed and restructured into private companies 10 to15 years ago.

"Quite a few failed but those that survived have done quite well – they have had to be good operators to survive. For instance, we invest in Haier consumer electronics, which sponsored a Sydney football team, and was state-owned from north-east China. It emerged through takeovers in an intensely competitive sector that saw consolidation into three or four players. This company is not tunnelling or getting benefits from parents.

"You have to look at a company`s record. Is it focused? If things go wrong do they just sit there like a government department – or work to turn around the business?"

How companies spend their money is a related issue for investors. State monopolies can get preferential benefits, and make a lot of money, but they have to spend it wisely, which was a problem Telstra faced. 

"Companies with strong cash flows do not always invest them efficiently," says Lai.

"In China, companies might get into new fields such as the property market at the wrong time. Money might be tunnelled to the parent company or go on poor investments elsewhere, or worse, instead of into the business or on to shareholders." 


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