“SOEs typically have a higher level of debts and are less profitable,” said Philip Li, senior fund manager at Hong Kong-based Value Partners. “But we can factor in that there’s room for improvement, particularly in light of the SOE reform to enhance their returns.”
There are examples of SOEs improving their efficiency. In telecom companies such as China Mobile, “middle-level managers actually get paid more than senior management because they are the ones who work to grow the business”, he noted.
“There are a lot of SOEs that don’t act like one. One company that we have invested in for a long time is a joint venture with BMW. The key operations are run by BMW, it’s just the joint venture is required by law and the government.
“Those are good opportunities for us: they are SOEs by structure and corporate ownership, but they are actually run by privately owned or global companies,” he continued.
Natixis Asia Pacific chief economist Alicia Garcia Herrero finds opportunities in the aviation industry.
“The airline sector is very oligopolistic,” Herrero added. “Because the massive demand is distributed among a small number of players, it improves the companies’ financials,” Herrero added.
Although 90% of the companies in China’s airline sector are owned by SOEs, they are financially healthy even when compared to global peers.
In particular, they have lower debts, according to a Natixis report that monitors the financial health of 3,000 largest listed Chinese companies.
“The aviation sector is correlated with a lot of other development plans, such as infrastructure, and the `one belt one road’ scheme which is expected to boost the traffic among regions,” said Gary Ng, economist at Natixis Asia Pacific.
However, a China equity research head of an asset management firm, who asked not to be named, said he preferred privately held companies in general.
“We stress the management quality of a company. At SOEs, the management team might be more stable, but with lower efficiency. And they would naturally prioritise the governments’ interests rather than those of other shareholders.
On the other hand, sometimes they can benefit from policy support, he added. “Some SOEs operate like a privately-held company, with strong leadership and motivation to create value for shareholders. That’s what we look for in an SOE.”
Private companies
Privately held companies have a different risk profile. “There’s greater risk of the chairman overruling the company’s management, even being arrested or disappearing,” Value Partners’ Li noted.
“Private companies would also be the first to feel the pain in an environment where the liquidity is tightened, resulting in higher borrowing costs.”
Greg Kuhnert, London-based portfolio manager of the Investec All China Equity Fund, stressed the importance of how private companies deal with the Chinese government and regulators. “If [they] tread on the wrong toes and fall foul of regulations in China, they can have the licenses taken away.”
A recent example is Tencent. Its stock price slumped 5% in a day after People’s Daily, China’s official newspaper, criticised its popular mobile game as “poison to players”.
The Investec team examines environmental, social and corporate governance (ESG) factors during the fundamental analysis stage, Kuhnert said. Corporate governance is the biggest consideration among the three, he added.
He said he didn’t like Alibaba’s shareholding structure, in which a small management team has a majority of voting rights. “But if you look across technology companies globally, there are other examples, such as Facebook. It’s not unique to China”, he added.
“The risks of this governance structure are typically around what the company does with the cash flow surplus,” he noted. Shareholders have no say in how the cash is used. “You have to make assumptions and hope [the management] is running in discipline with the cash flow generation,” he explained.
“The company has to be specific around how much capital it is going to commit to new areas. As long as the investments are not too enormous and do not dilute shareholder’s returns significantly, the shareholders should tolerate it,” Kuhnert said. “Otherwise the company might end up missing out on the next growth opportunity.”
