‘Value-Up’ Arrives in China

Are investors overlooking the potential for governance reform in China? From the ‘Nine Point Guidelines’ to SOE reform and fiscal stimulus, here’s why ‘market value management’ could be the next watchwords for China.

If there is a thin end of the wedge as regards corporate governance, then emerging markets have often been in focus. Within emerging markets, those countries characterized by high state ownership and state intervention in the allocation of shareholder capital are often found deserving of scrutiny. China has been high on the list of suspicion of regimes having an ambiguous stance on shareholder value creation. If there is an established playbook for corporate governance reform, then Japan has set the mold. For over a decade, market participants attempting to extract alpha from governance reform have primarily focused on Japan. Korea joined the party earlier this year with their ‘Corporate Value-Up Program.’ We believe there are similar changes taking place in China that may be underappreciated by investors. We also believe that aspects of the recent fiscal stimulus measures are designed to accelerate these changes.

The Chinese Plan for the Long Term

China economic strategy is characterized by long-term political planning. When it comes to capital market development, Chinese policy makers have issued reform plans known as the ‘Nine Point Guidelines’ every decade since 2004, with the 2024 version the third ‘Nine Point Guideline’ plan. While previous plans were focused on the development of many different asset classes, the 2024 plan almost exclusively focuses on improving the health of the equity market and underpins the recent drive for better corporate governance. It would appear that policymakers in China now taking action to address the challenge presented by aging demographics and a chronically under-funded pension system. Improving investment returns from the equity market is likely to be an important element in solving this problem, as well as returning the wider economy to a stronger footing.

It Started with SOE Reform

State-owned enterprise (SOE) reform first started in China in 1992, but it was only in 2023 that the reform agenda moved in a direction that definitively benefited minority shareholders. Unlike Japan, which has spent over a decade encouraging changes in governance structures within their listed companies, China appears to have gone straight to the end game. Every year, the State-owned Assets Supervision and Administration Commission of the State Council (SASAC) releases a list of Key Performance Indicators (KPIs) for SOEs. In January 2023 ‘return on equity’ and ‘operating cashflow’ were added to the list of KPIs to replace ‘operating margin’ and ‘net profit’. These changes had the result of shifting focus away from growth for growth’s sake and towards more efficient capital allocation. Then in January 2024, SASAC added another KPI which we think was an even more powerful catalyst for change. The new KPI was ‘market value management,’ which meant SOE management would now be assessed on their ability to increase the market value of their company. The result of these changes was that many SOEs increased dividend payout ratios, began repurchasing shares and improved dialogue with, and disclosure to, their shareholders. This led to significant outperformance of SOE company shares.

It Continues with non-SOE Company Reform

Starting in late 2023, the Chinese authorities turned their attention to non-SOE listed companies. Initially the focus was on putting the brakes on the IPO market as it was clear that the quality of newly listed companies had become questionable. They also tightened rules on margin financing and put restrictions on the ability of controlling shareholders to divest. Then in November 2024 the CSRC released the document called ‘Supervision Guidelines for Listed Companies No. 10—Market Value Management’ which we believe has the potential to trigger material change in how Chinese companies are governed and make decisions in relation to shareholder value. This regulatory guidance requires listed companies to focus on ‘enhancing company quality’, ‘boosting operational efficiency’, and ‘increasing profitability’. The following is translated from the original text:

‘Listed companies are encouraged to lawfully and compliantly use M&A, equity incentives, cash dividends, investor relations management, information disclosure and share repurchases to elevate their investment value......Listed companies with price-to-book ratio below 1x for over a year are required to develop value enhancement plans and address the progress in annual results briefings.’

These pronouncements are almost identical to those promoted in Japan since early 2023 and South Korea since early 2024 which, in both cases, have led to significant outperformance of companies that took action.

Fiscal Stimulus to Accelerate Governance Reform

The fiscal stimulus first announced in late September 2024 resulted in a huge rally in Chinese equities. While much of the focus of market participants has been on how effective this stimulus will be at addressing the issues of the property market downturn and local government debt, there is one element that we think has a direct link to governance reform. On 18th October, the PBOC launched the ‘Central Bank Lending Facility for Share Buybacks and Shareholding Increases’ facility. This facility will allow 21 financial institutions to issue loans to qualified listed companies for share repurchase. The cost of this lending also comes in at a very attractive interest rate of 2.25%. We believe this lending facility to be explicitly linked to the ‘market value management’ guidance from the CSRC and adds liquidity to facilitate a more compressed timeline of corporate action.

Is Governance Reform in China Sustainable?

The international investment community’s retrenchment from Chinese equities in recent years partially reflects a view that the Chinese authorities are anti-private enterprise and anti-shareholder value. It’s not so long ago that the financial press was full of headlines related to cuts in banker pay and political attacks on their lavish lifestyles. We have also seen a barrage of anti-trust regulation aimed at suppressing the dominance of individual private enterprises. These government actions may understandably make one question how committed the government is to the recent embrace of ‘market value management.’ If one assumes that China’s current macro troubles are partially related to misallocation of capital in the corporate sector, then the authorities have a major incentive to enforce good corporate governance and make it stick for the long-term. Also, if China’s Achilles heel, for shareholder value creation historically, has been related to adverse state intervention, perhaps, perversely, positive state intervention in corporate governance is a uniquely Chinese solution to these macro problems. We know from previous government policies that when the authorities put their mind to something, they usually deliver. That said, our experience in Japan and South Korea shows us that picking the right companies is crucial as there has been a wide spectrum of responses. In the short-term, the opportunities are likely to be concentrated in the SOE-dominated sectors of Financials, Energy, and Telecom. But if this initiative is successful, then it could lead to a decline in the equity risk premium for all Chinese equities, which would benefit many of the higher-quality private sector companies too.

The Role of Governance for Active Fundamental Equity (AFE)

As long-term investors, assessing corporate governance is an important aspect of the Active Fundamental Equity team’s investment process. Corporate governance is ultimately the mechanism that controls the extent to which value is created or destroyed by a company and how that change in value flows to the various stakeholders of the company and is therefore a critical factor in our decision on whether to invest in a company.