Cracking the China conundrum

How can investors get comfortable with corporate governance in China and broader emerging markets?

Key points

• To invest in China it has always been crucial to have a good understanding of (and alignment with) China’s policy initiatives, and the prevailing macro trends.
• That starting position has not wavered, but what is changing are the policy initiatives and macro trends themselves.
• China’s economy is no longer in a high-growth stage and it is changing rapidly, but it has developed world-leading companies in strategically important areas such as solar energy and electric-vehicle batteries.
• In seeking to invest in companies displaying high-quality governance, it is important to understand who we are aligning ourselves with, their core competencies, and the company culture they are promoting.

China remains a conundrum for many investors: a source of dynamism and growth potential, and yet, like many other emerging markets, often somewhat opaque in terms of governance.

Our view is that China remains a compelling investment destination, but to get comfortable with investing there requires an appreciation of the backdrop that one is operating in, and a demanding level of due diligence on the companies that one might want to own.

In terms of understanding the investment backdrop, we believe that it has always been important to have a good understanding of (and alignment with) China’s policy initiatives, and with prevailing macro trends. That starting position has not wavered, but what is changing are the policy initiatives and macro trends themselves. We see several fundamental shifts:

• China is no longer in a period of exceptional growth

China is now the largest economy in the world on a purchasing power parity (PPP)-adjusted basis. GDP per capita is now 11 times higher than it was 20 years ago. Debt levels are now bloated, with private-sector debt to GDP at more than 200%. China’s working population is also expected to decline by about 160 million people over the next 30 years.

• China’s economy is experiencing a huge amount of change

We will witness major winners and losers from this change. Certain areas of growth are no longer secular – gross capital formation is bloated at over US$6 trillion per annum, and the real-estate industry is too large at around 30% of GDP. Even in the e-commerce sector, China is already seeing the highest levels of penetration globally. These industries have broadly served their purpose, so it should be no surprise to see greater regulation and less government support for them. We believe sustainably higher levels of growth will be easier to find in undersized industries that both the government and society need. We think this is most obviously found by focusing on areas dealing with upgrading China’s economic infrastructure. For us, this means focusing on semiconductors, software, industrial automation and health-care research and development.

• China has globally leading companies in many strategic industries

China consumes almost twice as much electricity as the US, and thus it is little surprise that we see Chinese companies leading the way in the solar-energy supply chain. China has also built around 1.5 million base stations for 5G mobile networks, versus around 100,000 in the US. We see a similar story in other strategically important areas, such as electric-vehicle batteries, where China dominates.

In terms of due diligence, we understand that there are significant issues in China, and a number of bad actors within China’s corporate landscape. For these reasons, and given China’s emergence as a superpower, we are set for an era of tensions between China and the US, or indeed the West more broadly.

Some take an extreme view, and argue either that these things don’t matter, or that you cannot invest in China at all. Instead, we believe it makes more sense to recognise that this is the reality and take the time to better understand the opportunities and pitfalls that result. As seasoned emerging-market investors, we think the answer is to make sure that you ask the right questions before investing, and to have sufficient expertise and resources at your disposal to do so.

Seeking high-quality governance

Many emerging markets, like China, are undergoing massive changes. There are also large variations in terms of institutional strength, the rule of law and property rights. In that sense, the governance backdrop in emerging markets is more complicated. But what we are looking for in terms of high-quality governance is quite simple: it is important to understand who we are aligning ourselves with, their core competency, and the company culture they are promoting. Specifically, we seek answers to the following criteria:

• Integrity
  This revolves around a company’s attitude to minority investors – can we see evidence of alignment on behalf of the owners and managers of the business? Many businesses in emerging markets are not created for the long-term benefit of foreign shareholders, and this can include many state-owned enterprises as well as promoters who have failed to bring minority shareholders along with them in the past.

• Competence
  We want to see evidence that the business has been built on merit, and preferably in a healthy, competitive environment, rather than via protectionism or patronage. Too much of the latter can create franchises that can look very strong for some time but are ultimately brittle in the face of changing political support.

• Culture
  We look to gain an understanding of the culture of a business, and how this leads it to attract and retain talent, intellectual property, customer relationships or other intangibles.

Link to franchise quality

The final, crucial, step is to understand how good governance then drives franchise and financial results. Too often in emerging markets we see people viewing governance as a restrictive, tick-box exercise where set rules can be applied. Instead, we think that it can be an immensely important factor in determining franchise quality. The ideal scenario is when such businesses are set against the backdrop of some of the secular growth opportunities we outlined earlier.

Finally, one of the most common questions we receive on the quality of governance in emerging markets is “how can you know?” Our ambition is to ask ourselves the right questions about the more qualitative risks we are taking on behalf of our clients. By doing so, we believe we can end up in a healthier ballpark when seeking to compound durable long-term investment returns in emerging markets.

Authors

Newton emerging markets & Asia equities team

The team who manage our emerging & Asian equity strategies