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The rise of Chinese state-owned companies in the face of the possible resurgence of markets

Date: September 28, 2023 Time: 11:01:09

The Chinese stock market continues to go through a difficult situation. Indices such as the Hang Seng fall more than 34% from highs, but the situation can turn around thinking in the long term in some companies. In fact, recent policy reform could make state-owned enterprises (SOEs) a strong point in a bearish Chinese stock market.

With high-quality assets that can generate a high and sustainable dividend yield becoming more attractive, state-owned companies could be a major investment theme this year, along with generative artificial intelligence. “China has become the place where investors are positioning themselves the most because of the discount at which it is trading,” said a recent report by JP Morgan.

“Inflows into China’s stocks (from abroad) skyrocketed to the highest level we’ve seen in 2023, close to $3bn on the day,” according to ExenteData data. The institutional investor seems to be betting on China and the range of alternatives that can be found.

In this sense, SOEs are an important part of the Chinese economy, as their total revenues account for nearly 70% of the country’s GDP, and make up the bulk of what are considered security-related and foundational sectors, such as energy, infrastructure, public services and finance.

“Given their importance, the government has carried out reviews over the years to better update and align these companies with changes in national objectives,” says Diogo Gomes, senior CRM at UBS AM Iberia.

The latest round of policy reforms aims to make public companies more competitive and bolster their profits. The work focuses on improving aspects such as technology, efficiency, talent and the brand.

Chinese regulators have urged investors to look at a broader set of metrics, beyond total assets or income, to include total profit, debt-to-asset ratio, return on equity, labor productivity per capita, the ratio of research and development spending to revenue, and the ratio of net cash flow to revenue.

“The greatest scope is oriented around the way of evaluating the benefits, so that companies have greater incentives to align their interests with minority shareholders”, argues Gomes. At the same time, Chinese regulators are expanding the definition of benefits.

The so-called “valuation system with Chinese characteristics”, first put forward last November, would go beyond standard valuation metrics and take into account the social contribution of these companies and their impact on the broader economy.

“The government’s call to reassess and reclassify public companies under the new system has been interpreted as a call to buy public companies, but even leaving this aside, higher dividends alone justify investors lending to them. tension”, analyzes the UBS AM expert.

However, any government reform poses problems. The inefficiencies of public companies are usually due to the principal-agent problem, since they are owned by the State.

Public companies (agent) and the State (principal) may have a conflict of interest or priorities. “For example, it is difficult to create strong incentives for the achievement of objectives for the directors of public companies when their participation in them is low and the remuneration does not reach a competitive level”, says Gomes.

Opportunity or crisis

That being said, SOEs have not been considered by investors for a long time. “We have lived through cycles of reforms of public companies before and we see obstacles for the current round… temporary from one to two years”, highlights the expert from the Swiss manager before explaining that the current moment represents an investment opportunity.

“SOE reform is one of the two big investment themes we have identified this year. Although the correction of the last few months has created attractive opportunities in other sectors, we are attentive to the effect of reflexivity: investors trade based on how they perceive market movements rather than the fundamentals of economic activity, thus creating a cycle self-fulfilled ”, he adds.

Although deposit rates at major banks and lending rates from the People’s Bank of China (PBOC) were lowered in June, consensus does not foresee a return to the large escalation stimuli of previous years. Instead, we think that specific support for consumption, housing and infrastructure is more likely.

“In our view, not much has been done to ease the burden of weaker profitability for many industries and companies,” says Gomes. Less favorable supply and demand dynamics and heightened price competition are putting pressure on the most energetic part of the Chinese economy, ie private companies, as is weakening confidence in disposable income growth.

Entrepreneurs are waiting, without investing proactively to capture future opportunities, because it takes time to restore confidence after what has happened in the last three years. “For this reason, I believe that the focus on state companies has come at the right time and place,” Gomes elaborates.

“If the current macroeconomic environment remains largely unchanged, SOEs could continue to outperform the broader market for longer under the new valuation system,” he adds. Thus, the expert believes that SOEs have the potential to continue outperforming the market in general in uncertain market conditions due to inflation and interest rates.

Puck Henry
Puck Henry
Puck Henry is an editor for ePrimefeed covering all types of news.

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