Investing in Asia: Grasping Corporate Governance Nuances Is Key
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What do swimming scallops have to do with investing in Asia?
A lot, according to S. Joyce Li, CFA, a portfolio manager at Matthews Asia.
It begins with a cautionary tale.
“Do you know scallops are good swimmers?” she asked the audience at the recent CFA Institute Equity Research and Valuation Conference 2018.
“Many investors learn that fact from a listed company in an unexpected way. A few years ago, there was a big seafood producer in Asia that invested heavily in expanding their scallop farm. Everything seemed to progress really well. Until one day, the company put out a surprising announcement. A large number of scallops disappeared. How? The management said, ‘Well, they’re just great swimmers. Maybe they just swam away.’ That’s not the end of the story though.”
She continued:
“After the stock price collapsed, the management quietly issued shares to themselves. Then, a few quarters later, surprise again, the scallops swam back to help the harvest. The only one who benefited from this story was the management.
“Why am I telling you this story? After all, you’re not at a seafood conference. I’m telling you this story because horror stories like this is one of the primary reasons why people are so skeptical of investing in Asia.”
Investors often hear about exciting growth in Asia but don’t know how to avoid disasters like that of the vanishing shellfish. And to complicate matters, indices in Asian markets are crowded with companies that have destroyed value in the past, Li said.
Why take the risk when cautionary tales like that of the disappearing scallops abound?
Because the market is too big for investors to ignore, Li said. And growth will continue, driven by the twin propellers of consumption and innovation.
“On consumption, we essentially have a continent of crazy richer Asians who drive the world’s best consumption story,” she said, referencing Crazy Rich Asians, the romantic comedy based on Kevin Kwan’s bestselling book about the struggles of an affluent — or “crazy rich” — Asian family. Asian middle-class consumers account for 30% of global middle-class consumption today. That number is predicted to go to 50% by 2030, Li noted.
On the innovation side, you need only look at patent applications and grants: From 2011 to 2015, Asian countries accounted for three out of five patent grants, according to Li.
“Asia is a fast-growing and big market with a lot of new growth drivers driving the investable stories,” she said. “Asia is no longer the Asia of 10 years ago. Asia is no longer the Asia of five years ago. When you look at investment opportunities, your impression from maybe five or 10 years ago by looking at the index companies can no longer capture the entire bottom-up growth opportunity picture.”
Yet investors are understandably skeptical. “We cannot forget about the story of the scallops,” she added. “How do we tap this market without falling into those traps?”
If you look at value creators in Asia — defined as companies whose five-year average return on invested capital (ROIC) is higher than their cost of capital — as opposed to value destroyers, the data is depressing at first glance: In quite a few Asian markets, there are more value destroyers than value creators, Li said:
“When you look at the number of companies who created value over the past five years, there were over 2,500 value creators across Asian markets and this is ex-Japan. In the extreme case, China A-shares, only 30% of the Chinese A-share market created value over the last five years. No wonder a lot of people say A-share is a casino or A-share is a jungle. If you look at the number of A-share companies that created value, that gives you 971 companies. That’s a much bigger investment opportunity set than some other countries put together.”
The critical takeaway is that there are many value creators, but investors need to spend the time sifting “through the bad apples to find them.” Unfortunately, “sell-side analysts in Asia have a lot of pressure from corporations and also governments for them to stay on their side,” Li said, and so they are rarely independent. The onus is thus on investors to do the work. Li believes the key to investing in Asia is grasping the nuances of corporate governance and understanding the ownership structure.
“The foundation of that corporate governance is to understand the unique shareholding structure and why it’s different and how it’s different in Asia,” she said.
In the United States, over 70% of average listed companies are owned by a diffuse group of institutional investors. In Asia, however, institutional investors only account for about 10% of ownership.
The bottom line? In Asia, “the corporations, which include the family business groups and governments, have a much bigger role in the ownership mix,” she said. “On average, corporations own 26% and government owns 18% of listed companies.”
The central question investors need to ask is: Are the controlling shareholder interests and the minority shareholder interests aligned?
“Misalignment between controlling shareholders and minority shareholders is the root cause of many problems,” Li said. There are four red flags in particular to watch out for, she said: revenue and profit manipulation; poor capital allocations; expropriation of cash and valuable assets; and hidden financial assistance to controlling shareholders.
She also recommends investors incorporate corporate governance nuances into their company research by focusing on four areas:
- Know the Controlling Shareholder: What’s the controlling shareholders’ story? How did they get their initial funding? Who are they connected to? What is their background and track record? Are there potential conflicts of interest with family members? Have the controlling shareholders had a history of misleading private or public investors?
- Know the Board: “You probably say ‘Why do I care? The boards are not independent anyway’,” Li said. “Quite the contrary. I think board quality is one of the best signals to help you define the best companies. Even the whole board is largely not independent, but who they place on the independent spot, especially on the audit committee spots, tells you a lot about what the controlling shareholders want to take his or her family business to over 10 years, 20 years, 30 years’ time.” Do they have good disclosure? Do they have a track record of fair oversight? Beware long tenure, “eyebrow-raising” backgrounds, and “over-boarding,” when a director sits on an excessive number of boards.
- Know the Cash: Li cautioned against assuming “cash is cash.” A good question to ask is: “Is the payout of dividends and also the growth of dividends consistent with its business model?” The cash conversion ratio of earnings is always the first ratio she looks at. Also pay attention to consolidated cash flow and non-consolidated cash flow. Warning signs include a capital raise despite a high cash balance, unreasonably low interest income on the cash, and excessive growth in non-productive assets. “It’s actually not that difficult for companies to fake the cash to auditors,” Li said.
- Go beyond Financial Disclosures: Follow the trail of executives and directors, especially if they engaged in questionable practices in the past. Search databases for tax and legal information and ask competitors and suppliers about market share and competition. And, finally, swing by in person. “I cannot overemphasize the importance and insights I get from the on-the-ground visits, including the office image,” Li said.
As for those swimming scallops, “if you’re still interested in investing in scallop farms, following those four steps hopefully [will help you] find scallop farms that truly give you scallops in the end. Or even better, superior returns,” Li said. “Or the rare scallop pearls.”
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
Image courtesy of Paul McCaffrey
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