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How to avoid governance risk in Chinese companies?

The view that governance standards in China fall short of international norms is widely held among investors but standards are slowly improving, analysts argue.

Sharukh Malik, an analyst at Guinness Asset Management, said there were a number of red flags regarding governance that fund selectors should look out for.

Family ownership of listed companies is certainly more prevalent in China compared to other markets, but Malik said it depended on the experience of the family members as to whether it posed a problem.

He said as many companies listed on the Shanghai Stock Exchange – which was founded in 1990 – are less than 30 years old and as a result, founder families can still hold a large share of the equity.

“Some people argue it’s a bad thing if there’s too much family control on a board. But it depends on a case-by-case basis,” he said.

“If the founder is the chairman they will have been with the company for a long time and know how the company works. If another family member is the CEO there can still be a clear separation of roles. It’s not necessarily a bad thing.”

Malik said another red flag was the number of boards a director is on and if they have been on the boards of companies linked to fraud. There have been instances when one executive has been on the board of as many as 10 companies.

Level of disclosure

Another issue can be the lack of disclosure on management pay, Malik said. Without proper transparent disclosure it can be unclear what motives drives management and if incentives are aligned with shareholder values.

MSCI’s move last month to increase the weight of China A-Shares on MSCI indices from 5% to 20% should encourage firms to improve governance, Malik said.

Malik added that while Chinese firms were slowly improving governance procedures it was more skewed towards large cap companies within the A-Share market.

“The better-known companies have the most contact with investors outside of China,” he said.

“For small and midcap firms, it often depends on how much contact they have had with western investors, and I would say many have not had much contact.”

Return on capital

Malik said it was vital to look at a company’s return on capital when analysing its governance.

“We think a good quality company that is governed well will have a return capital well above the cost of capital,” he said.

“We look for companies that generate a persistent return on capital over time because you can have a lot of subjective views as to whether a company is governed well.

“And a lot of those views count but we think you need a solid metric to underpin the argument behind that.”

Malik noted that he looked for companies that generated an 8% cash return over investment capital over at least eight years.

“If a company is well governed it’s going to have good returns. But if you’ve got someone [in charge] that doesn’t really know what’s going on and just listens to the head of the family then those returns tend to fade,” he said.

Jassmyn Goh

Jassmyn reported from Sydney to New York to Jakarta before joining Expert Investor. She was most recently Features Editor at Money Management and Super Review in Sydney.

Part of the Mark Allen Group.