A reputation at risk
By Sundeep Tucker, Jamil Anderlini and Robert Cookson
Published: January 5 2010 02:00 | Last updated: January 5 2010 02:00
An ageing William Simon, US Treasury secretary under Richard Nixon, once famously remarked that if he were 40 he would move to Hong Kong to take advantage of the China story.
Two decades on, the country's pull has grown so powerful that a veteran such as Anthony Bolton, one of Europe's most renowned stockpickers, has shelved his retirement plans to make precisely that move. Instead of decamping to his Caribbean home to indulge a passion for composing music, London-based Mr Bolton, who turns 60 in March, is preparing to relocate to Hong Kong to launch a China-focused mutual fund.
He achieved legendary status during his 28 years at Fidelity International's Special Situations fund, during which time it delivered an annualised return of 19.5 per cent. Now, he explains: "The centre of gravity is clearly shifting to this part of the world and I want to play a part in it while I can. The investment opportunity is simply too great to pass up."
China's economy continues to expand rapidly and global portfolio investors cannot afford to ignore its biggest companies, many of which are the world's largest in their sectors measured by market capitalisation. But picking Chinese equities is not easy. Beijing's authoritarian capitalism makes its stock markets radically different from those in the west. Also, despite their size, few large companies are globally competitive.
Mr Bolton's decision to risk his reputation in this unpredictable market is being watched closely throughout the investing world. His success, or failure, is likely to influence the approach to Chinese stocks of countless other foreign investors.
Certainly, huge amounts of portfolio flows have been heading into emerging markets, including China-related stocks listed in Hong Kong. Tens of billions of dollars more are forecast to flow into China annually as investors scramble for an exposure to the world's fastest-growing companies in their quest todeliver higher returns than their peers. Emerging Portfolio Fund Research, a data provider, says mutual funds that invest only in China experienced a net increase in subscriptions of $5.4bn (£3.3bn, €3.8bn) last year compared with 2008, a 60 per cent rise. Total assets under management doubled over the same period.
The special challenges for any foreign portfolio investor include the difficulty of assessing whether local management teams are genuinely focused on shareholder value; coming to terms with the government's omnipresence across industry; and, not least, the problem of how to find investment opportunities.
Unlike their western counterparts, Chinese companies tend to focus on measures such as size, market share and revenue, which do not necessarily create higher shareholder value. This is at odds with how global fund managers base their decisions - on details such as earnings per share, return on equity and the consistency and transparency of a company's operations.
In fact, Chinese share prices are often driven by speculation and liquidity, say analysts. A look at the flagship Shanghai Composite Index over the past three years illustrates the point. The index was the world's best performer in 2007 and the worst in 2008. Last year it had almost doubled before it crashed in August - but still managed to end 2009 some 80 per cent higher than it began.
China launched its stock markets in Shanghai and Shenzhen less than two decades ago as part of reforms designed to foster growth. Fund managers in those early days of mainland equities - including Jing Ulrich, now head of China equities and commodities at JPMorgan - had concerns about transparency, liquidity and management accountability. She notes that things have improved "dramatically" but remains cautious about the link between economic growth and stock market success. "People do not doubt that macro economic growth will be robust," she says. "Whether that growth can translate into healthy corporate profits is not a foregone conclusion."
Nor should Mr Bolton necessarily expect the skills that made him a star fund manager in Europe - his ability to identify and back the right management, for example - to translate easily. "His experiences in London will only be of limited value in the Chinese market as he neither reads nor speaks Chinese," says Fraser Howie, co-author of Privatizing China and a banker long focused on the country. "It will be very hard for him to get to know and really understand management of Chinese companies."
The vast majority of listed companies remain majority state-owned and senior management appointments are made by the Communist party. As a result, senior executives always have an eye on their political responsibilities. Investors hoping to back successful management teams of state-controlled companies must be prepared for their favoured chief executive or chairman to be transferred suddenly to the helm of a rival company or the governorship of a province.
Such musical chairs occur periodically in leading sectors including telecommunications, banking, aerospace and petrochemicals, still heavily regulated by Beijing. One of the more memorable reshuffles was three years ago when senior executives at some of the biggest banks were moved abruptly, underlining the fact that the government retained control in spite of partial privatisation through overseas listings. Those shifted included Zhang Jianguo, then president of the Bank of Communications, the country's fifth-largest lender, who became vice-chairman of China Construction Bank, the second-largest. HSBC, BoCom's leading foreign shareholder and strategic partner, was not consulted.
An even more unpleasant surprise awaits those who wake up to find yesterday's market darling has been arrested on corruption charges. In 2005, Bank of America and others who bought shares ahead of the flotation of China Construction Bank were dismayed to see Zhang Enzhao, the bank's president, taken into custody just a few months before CCB was scheduled to list in Hong Kong. He was convicted and sentenced to 15 years for taking bribes totalling $530,000 in exchange for arranging loans.
CCB was able to secure a waiver of Hong Kong's demand for continuity of management for at least one fiscal year before an initial public offering but the case provided a wake-up call for international investors.
The legal peculiarities of a one-party state are not confined to high-profile criminal cases. "China has a legal system but enforcement is missing, particularly on things like intellectual property and contractual issues," according to Jack Perkowski, managing partner of JFP Holdings, who after 20 years on Wall Street has spent the past 15 years in China. He warns investors to be "very careful looking at competitive positions of companies in China because it is such a competitive market with tremendous price pressure on most products". For example, a market leader can quickly find its intellectual property has been stolen, its products copied and its price position undercut.
The increasingly large pools of capital - one result of an abundance of domestic liquidity, government restrictions on Chinese investing abroad and the rise in numbers of professional domestic investors - and the relatively few well-managed private enterprises mean Mr Bolton faces fierce competition. "The number of people coming to invest here compared with the number of good investment opportunities is completely out of synch," says Mr Perkowski.
Meanwhile, as many point out, the stock market is riddled with insider trading, market manipulation and government interference. Furthermore, there is little correlation between headline growth rates and share prices.
When Mr Bolton does decide to make investments, he will not be able, at present, to buy the fast-growing stocks listed in Shanghai or Shenzhen. Foreign portfolio investing in mainland-listed shares is allowed only through quotas granted by the state-sanctioned Qualified Foreign Institutional Investor scheme.
China had granted QFII quotas with a combined value of about $15.7bn to 78 foreign groups by the end of September, according to the State Administration of Foreign Exchange. Beijing is this year expected to hand out quotas worth an extra $5bn.
While Fidelity awaits a response from regulators for its own quota application, Mr Bolton will either have to invest in Chinese companies listed in places such as Hong Kong, London or the US or rent a QFII allowance from a licence holder.
Mr Bolton insists he has the skills and experience to deliver for his investors. During his tenure, the special situations fund successfully invested in Chinese companies, including some "A shares" - Chinese-listed and largely restricted to local investors. During his regular visits in the past five years, he also has gained experience of working with Chinese management.
He points out that he decided against investing in Gome, the electronics retailer, after meetings with executives left him uncomfortable with its management and accounting. The company was seen as a sure bet on growth in consumer demand but, since the arrest of Gome's founder a year ago on insider trading and bribery charges, its Hong Kong-listed shares now trade at roughly one-sixth of their price at the start of 2008.
Mr Bolton will benefit from Fidelity's established research and analyst presence in Hong Kong. Its China Focus fund, with stocks worth $4bn, is managed by Martha Wang, a Mandarin speaker with 16 years' experience researching Chinese companies. Indeed, many of Fidelity's 30 Asian regional analysts and 18 portfolio managers speak the language. Some will accompany Mr Bolton to meetings with company managements, providing not only translation but local intelligence.
The strategy and size of Mr Bolton's fund is yet to be decided. He does say, however, that it will make larger bets than Fidelity's existing China funds and will be run according to his style, characterised by bottom-up investing with contrarian calls.
As well as his stock-picking skills, Mr Bolton says he will bring a fresh perspective and an ability to spot emerging trends in new industries given his experience of developing European markets in the 1980s and beyond. Chinese companies in services and pharmaceuticals, for example, are expected to benefit from policies to support domestic consumption, develop new industries and promote a greener economy.
"The spotlight is on me and I have to outperform," he says. "I am keen to get started, and we'll see what happens."
Investment restrictions
To put together a Chinese portfolio, first sift through an alphabet soup
It is one of the many oddities related to investing in China-related equities that portfolio managers often draw on both atlas and alphabet when thinking about stocks , writes Sundeep Tucker .
Chinese companies are listed on exchanges all over the globe. But Beijing permits foreigners to trade the 1,620 stocks listed on its domestic exchanges in Shanghai or Shenzhen only if they hold special licences. Those licences give them access to quotas of individual stocks, worth on average $100m-$200m each - still too small to make a genuine difference to global fund managers.
Shares listed on domestic exchanges are classified into two types, A and B. The former, originally for local investors only, are the most common, although a few domestic companies continue to list B shares, previously the only kind that foreigners could trade.
The majority of global investors therefore have little access to A or B shares, potentially the fastest growing Chinese stocks of all.
Foreign investors can, however, invest freely in the "H shares" of companies domiciled on the mainland but listed in Hong Kong, which has no capital controls. There are more than 100 H shares, such as those of the Chinese banks that dominate global industry rankings by market capitalisation and deposits.
To make matters more confusing, many Chinese companies are listed as both A and H shares, and stock prices of the same company can trade at wildly different levels across the two markets.
Hong Kong is also home to 34 "red chips", mainland companies incorporated outside the mainland but listed in the city. They include China Mobile, the world's biggest mobile phone company by subscribers, and Cnooc, the state-controlled oil group.
Other Asian bourses areengaged in a battle to attract the hundreds of Chinese companies that want to raise capital but are stuck in the queue behind others waiting for a listing in Shanghai or Shenzhen. Singapore has led the way and today hosts 124 "S chips".
Outside the region, some Chinese companies have listed in Europe or the US. London has about 18 and, according to JPMorgan, there are 46 listed on either the New York Stock Exchange or American Stock Exchange. About 75 mainly technology-related groups have meanwhile migrated to Nasdaq to gain access to specialist US investors who, they believe, will understand their business prospects better than locals and therefore have the potential to boost the share price.
Fund managers looking to play the China growth story could also invest in non-Chinese companies exposed to the country. This could, for example, involve buying the Brazil-listed shares of Vale, the mining giant that ships iron ore to China.
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