China Corporate Governance: How to avoid pitfalls?

20 years ago, the first corporate governance code was introduced in China by the CSRC (China Securities Regulatory Commission). Since then, corporate governance in China has improved and the financial markets have gradually opened up more and more. We spoke to Nidhi Mahurkar, Investment Director at Ninety One, about the opportunities for investors, the pitfalls and what role corporate governance factors play in her investment decisions.

AsiaFundManagers.com: What are currently the biggest corporate governance risks for investors investing in Chinese stocks?

Nidhi Mahurkar: China’s equity market represents a diverse set of opportunities, with varying standards and levels of disclosure on environmental, social and governance (ESG) issues. Private companies and state-owned enterprises (SOEs) in China often pose risks of misalignment of minority and majority shareholders, while there is high ownership concentration. The founders may have stakes in many businesses and pledge some of their holdings in the listed entities to fund other investments, creating ‘zombie’ owners and potential control risks. There may also be complex and well-hidden related party transactions (where the company or its subsidiaries transact with persons or entities with whom it has direct or indirect interest) that can help inflate earnings and divert cashflow to particular uses. Moreover, independent shareholders’ influence on board decisions is usually very limited. Although SOEs have lower risks of outright accounting fraud, there is the risk of non-transparent control, with some SOEs operating through opaque holding entities.

As China opens up its financial markets and gains wider representation in global indices, we are seeing an improvement in ESG standards and disclosure, albeit from a very low base. As a result, we believe taking an active investment approach is important to appropriately assess investment opportunities, taking account of the risks involved.

AsiaFundManagers.com: What are the main differences in terms of corporate governance between Chinese and Western companies?

Nidhi Mahurkar: Western companies have matured more in terms of quality and scope of ESG disclosures. Larger Chinese businesses with global exposure – many of which have international listings – tend to have higher-quality disclosures that reflect the global standards that management expect to be judged against. However, Chinese onshore companies – stocks that trade in mainland China on domestic exchanges – have lower disclosure rates than stocks listed on the MSCI All Country World Index. Encouragingly however, this is changing, spurred on by greater scrutiny from increasing international investor participation in this market, assessing companies against global ESG standards.

AsiaFundManagers.com: What role do governance criteria play in your investment decisions? How do you weight these factors?

Nidhi Mahurkar: There are some key red flags that we look out for – abnormally high revenue growth or margins compared to peers, unnecessarily complex corporate structures, frequent change of management and a mismatch between profit growth and cashflow. However, this is only a summary of some common red flags.

In practice, problems could be hidden within complex related-party transactions and accounting manipulation and are therefore more difficult to detect. This is why we stay focused on learning from the broader market experience and case studies to keep enhancing our analysis skills. Corporate governance criteria play a key role in our fundamental analysis and also inform our assessment of where we can engage with companies and influence material change.

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AsiaFundManagers.com: What sources do you use to assess a company’s corporate governance practices?

Nidhi Mahurkar: We use third-party research and ratings as a guide, but we also must carry out comprehensive fundamental analysis, including direct contact with companies of course. We write a detailed ESG report for each of our companies, which includes an in-depth assessment of the unique ESG factors as relates to that company. To deepen this assessment, we use two external datasets we deem particularly useful:

1 – MSCI complements our own thinking on where the materiality of risks is in any given company or sector.

2- RepRisk leverages advanced machine learning to identify real-time controversies related to a particular company.

Third-party data providers have been working on increasing coverage and rating Chinese stocks, but data availability and consistency remain hurdles. The proprietary red and green flags that our team have developed help us mitigate potential risk and highlight potential opportunities to explore further.

While these flags are helpful indications, we do not make assumptions without proper fact finding and engagements. This includes asking direct questions about how companies are managing their operations, especially for products and services that are subject to increasing social and environmental scrutiny. We use this to gain insights into a company’s strengths and weaknesses along with our fundamental analysis. We also evaluate the culture of open exchange when requesting information, allowing us to open up a dialogue with the company on ESG issues.

AsiaFundManagers.com: Thank you very much for the interview.

Nidhi Mahurkar
Investment Director
Ninety One

Nidhi Mahurkar is Investment Director for 4Factor, emerging markets, Asia and China strategies at Ninety One. She reinforces the client-facing function both in terms of client management and marketing products across strategies, regions and channels. She also provides input on product strategy to address new commercial opportunities within this product suite.