Finding stewardship in China

How do you think the Stewart Investors’ investment philosophy is suited for investing in China?

There are many good quality companies in China which we believe have a bright future. We currently find the valuations of these companies excessive. 

Most companies we encounter in China are very opaque. Complicated holding structures, weak boards of directors, unusual balance sheets and a weak regulatory environment add to our general concerns. We often find that our concerns are not reflected in current valuations, as many market participants focus on the very short-term financial results.  

It is interesting that while we find both high and low quality companies overvalued, from our perspective, there is little correlation between quality and valuation in China. This relationship is much clearer in most  other markets.   

Being benchmark agnostic, our investment philosophy enables us to pick only the owners and managers we trust and businesses we understand. We believe this small sub-set of companies has a greater than average chance of success over the long term. 

Can you remind us why you believe governance is so important?

Governance dictates the long-term success of any business. In our view, a well-governed business maintains the financial flexibility to survive crises, invests consistently to drive the franchise forward and treats minority shareholders fairly, as well as other stakeholders such as community, employees, and customers. We have never relied upon the typically weak institutions of emerging markets to restore client losses in the event of a management team or owner disadvantaging its shareholders, which is why the integrity of, and  governance of, the company has to be our starting point everywhere.

Governance can be assessed in many ways, and is highly subjective. In China, this assessment may be even more important than in other markets, given its closed capital account and the relatively immature Shanghai-Hong Kong Connect, which may result in investors being unable to sell securities during a time of extreme market stress.

Where are the most interesting opportunities?

We have focused on true private-sector businesses and the sectors where we spent the most time were industrials, healthcare and consumer companies. We do consider select state-owned businesses where we can evidence a thoughtful treatment of minority shareholders and a focus on returns on capital. In a landscape where private-sector ownership can be desperately opaque, the flaws of state-ownership are sometimes buffered by certainty of ownership.

We shy away from sectors with frequent corruption scandals, such as mining and property, and also avoid the ‘commanding heights’ of the economy – the largest banks or oil companies, but also those notionally private-sector tech and fintech companies which handle the personal communications and financial data of the nation. China has very high debt levels – we aim to avoid highly indebted businesses, but we are also wary of companies which may be asked to ‘do their bit’ to help out. 

How easy is it to research owners and managers of businesses?  

The lack of a free press, a restriction which obviously extends to the content of financial reports written by investment banks, both domestic and foreign, means that information is less readily accessible than it might be in other countries. China is not, however, unique in this regard, and there are plenty of examples of relations between tycoons and politicians being suppressed in countries typically seen more favourably in terms of transparency, such as India or South Korea.

The only response we have to a lack of information is patience. Because we genuinely enjoy trying to understand companies as well as possible, we have never seen reading one more annual report or spending another day digging through an initial public offering (IPO) prospectus as bashing our heads against a brick wall. We seek to own only around fifty or so companies in any fund and we wish to own each company for many years – patience and high standards go hand in hand.

Our meetings with companies are a critical part of what we do, as that is where we get an opportunity to tie up whatever historical and governance loose ends our desk research has found. Although not every meeting leaves a perfectly clear picture, we are confident that continuing to spend time understanding qualitative issues, such as an owning family’s value system, is far more worthwhile than adding false precision to distant revenue forecasts – we are often told we ask unusual questions and have decided (on balance!) to take this as a compliment. 

What are your thoughts on valuations?

Valuations continue to be excessive for many of our favourite companies in China. We’ve seen the stock market correct many times in the last decade and we are prepared to take advantage when the next opportunity emerges.

Stock market memories are short – many have forgotten that in 2015 the Shanghai stock market fell by about a third in only a month or two.1 Government entities were forced to support prices, many companies suspended their trading altogether, and there were arrests of market participants for making unhelpful comments. The Chinese financial system six years later is larger, more complex and more indebted than it was in 2015. It is debateable whether the companies are of higher quality or not – there are certainly many more companies boasting huge market capitalisations, but at an operating level they are loss making (much of the electric vehicle industry and some online retail businesses for example).

Could you give us an example of a company from your recent virtual trip that is of interest? 

China Resources Beer, and its previous incarnation China Resources Enterprise, has been a stock the team has followed for years. It is the largest beer company in China. Following a transaction in 2019, it is now controlled by a company that is owned 60/40 by China Resources and Heineken NV. 

Heineken NV and its subsidiaries are found across our clients’ portfolios. We have tremendous respect for the family-owned company. China Resources is a state-owned enterprise, but has long been one with high standards of corporate governance and minority shareholder protections.   

While the company is a leader in volume, its margins leave much to be desired. Our expectation is that with Heineken’s premium brands and mentorship these margins can grow. 

What about a company you haven’t known for quite so long?

AK Medical specialises in the design and manufacture of orthopaedic implants, and was founded in 2003 by an orthopaedic surgeon who had worked for a foreign competitor in China. Today he and his wife own a controlling stake, having listed the company in 2017. 

In a report written last year, we examined the company’s unusual attitude to R&D, and its distinct long-term vision to be a technological leader, rather than simply aiming for revenue as a distribution-led franchise which we would view as lower quality. It became very clear that its culture of long-termism differentiated it from domestic competitors and its cost advantage should one day give it the edge over multinational peers.    

The implant market is growing rapidly as affordability improves. The great uncertainty for us concerns government attempts to reduce costs to the healthcare industry, while further expanding accessibility – to our minds the Chinese healthcare industry is valued by the stock market as if it is following the US model of extremely high profits, despite an increasing amount of evidence that the powers that be in China would prefer to be somewhat closer to the European model of state-influenced benefits of scale and the lower prices and margins this causes.

Alex Summers
March 2021

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