Corporate governance is one of the areas that professional investors pay the closest attention to when assessing a company. The difference between good and bad corporate governance is intangible, often subtle and can take many years to have an impact on the bottom line, which is why it is an area where experienced fund managers feel they can add value.
That’s the theory anyway. However, when a board of directors who arrive at an office to retake control of their operations are water-cannoned by the local Chinese management team, it doesn’t take a genius to work out this should be filed under “bad corporate governance”.
This is one of a number of scenarios highlighted in Janus Henderson’s Signals and Smokescreens report, which looked at 60 high-profile company failures in China to search for common threads that the asset manager could incorporate in its stock-selection process.
Michael Kerley, director of pan Asian equities at Janus Henderson, said the publication of this report is timely, with the inclusion of Chinese A-shares in the MSCI indices. He pointed out China will be the second largest equity market if – and when – the Shanghai and Shenzhen exchanges are given full weighting.
However, he warned that while China should no longer be classed as an emerging market, investors should not treat it as a developed one either, pointing to a number of spectacular corporate governance failings that wouldn’t be possible in areas such as Europe, the US or Japan. Aside from the company that water-cannoned its board of directors, these include:
- • An independent director, who was accused of negligence for failing to detect wrongdoing, arguing that he should not be punished because he “always regarded an independent directorship as an honorary title”, “knew nothing about the operation of the company” and “did not have the ability to understand the accounting sheets”
- • A chief financial officer who resigned after the board “denied him sufficient access to the financial records”
- • A company that made a public announcement on NASDAQ that its chief executive had fired the external auditors half way through the audit because they had asked to see the bank statements, a request that was deemed to be “overly broad”
“There are different ways people look at China – some just use a quant screen and say ‘this looks wrong and this looks right’,” Kerley said. “But we think it is about more than just the numbers because there are certain things that happen in China that don’t happen in the rest of the world.”
The manager said that China is unique in that it is centrally controlled by a communist party which is allowing wealth creation. It is deliberately taking this step because it believes economic stability will result in political stability, helping it to achieve its main long-term goal – remaining in power.
The Signals and Smokescreens report expanded on this point: “The government regulates the markets closely by controlling the flow of companies that are allowed to list both on the domestic markets and the global stock exchanges.
“Important state-owned enterprises that contribute to the realisation of government development strategy will find it much easier to access both the international equity markets and domestic debt.”
“That’s really important,” Kerley (pictured) added. “When you look at the market, a lot of people will say ‘China just wants to be like the US’.
“It doesn’t and it never wants to. It’s a growth strategy with Chinese characteristics and those characteristics won’t change.
“That is probably one of the most important things to draw out of this.”
After analysing previous company failures and the factors unique to China, the authors of the Signals and Smokescreens report put together a list of seven red flags where their previous occurrence have preceded periods of “intense financial stress” resulting in “substantial destruction of shareholder value”.
These include suspect financial ratios – for example, one scrap metal company reported revenue growth and outputs that far exceeded those of its nearest competitor. However, a closer look at its figures revealed it would have had to have imported more scrap metal in a single month than the Chinese Ministry of Environmental Protection permitted in a whole year.
In another case, a forestry company claimed to harvest more than 1 million metric tons of woodchips a year, but had only $200,000 of depreciating fixed assets, as the balance was still “under construction”. Further inspection showed the only fixed assets that were depreciating were vehicles; this logging company had no logging equipment.
“Although the numbers are always a good starting point for making an informed and successful investment decision, they must be analysed in conjunction with a full understanding of the industry in which the company operates,” Kerley continued.
“Behind the numbers may lay an opportunity or a risk – only in-depth analysis will determine which it is for investors.”
Another, arguably more important red flag, is a lack of board oversight. Of the 60 company failures analysed by Janus Henderson, three-quarters indicated poor alignment between the interests of the controlling shareholders and minority public investors.
Examples here include boards of directors that exhibit: a high proportion of family members or “decorative” appointments, who have respected academic qualifications but little business experience; a high turnover; a lack of experience in China, including an inability to read Chinese characters; and “impulsive strategists”.
One case of the latter involved a manufacturer of LED lighting, which suddenly bought a second tier French football club. The chairman said that while he had initially been against the acquisition because he “didn't know anything about the football business”, he changed his mind because “President Xi wants to promote football in China, so it’s a good relationship crossover”.
Charlie Awdry, who runs the Janus Henderson China Opportunities fund, said that while the report focused on red flags, it also contained a number of green ones too that should help to reassure investors that a company can bounce back after its share price has taken a hit.
Most important of all from a corporate governance point of view is directors with “skin in the game”.
“We want directors on those boards who have something to lose – this doesn’t just mean money, it can mean their reputation as well,” he explained.
“If they have this incentive, they will be commenting on, cajoling, trying to get some of these fast-moving controlling shareholders to question themselves and ensure that minorities and the general trend of the companies is moving in the right direction.”
Kerley said that investors should not allow the corporate-governance horror stories to deter them from investing in China, adding that its unique political structure has many advantages as well.
For example, he pointed out the manifesto pledges made by developed-world politicians before an election often end up having little relevance to the defining moments of their time in office.
“But in China, you have a five-year plan and in that respect it is probably the most predictable economy – because they have a have a five-year plan, they tell you what they are going to do and they have a very strong track record of doing it,” he said.
“Xi Jinping is probably one of the most credible leaders out there at this point in time. And actually, with Xi Jinping, we have a plan to 2050. You can’t imagine Donald Trump coming out with that – you’d be surprised if he had a plan for the next 15 minutes.”
Performance of manager vs peers over career
Source: FE Analytics
Data from FE Analytics shows Kerley has made 322.44 per cent since he started his career in December 2004, compared with 377.7 per cent from his peer group composite.