China, Explained series: How to find quality corporate reporting in China?

According to The China position survey in September 2019, over 40 percent of institutional investors say their biggest obstacle to investing in China is the lack of transparency in its financial system. Over a third of respondents with no dedicated exposure to China, say better corporate reporting would go a long way to alleviate their concern. Where can investors find complete and accurate corporate data on China? We speak with Senior Portfolio Manager, Chris Liu, to understand how corporate reporting works in China and where to find quality data on its companies.

Q: Investors cite concerns about the lack of transparency in Chinese companies and their auditing practices, some are listed on overseas bourses. What are the key differences in financial reporting practices in China compared to international standards?

The listed companies in the A share market follow the domestic Chinese Accounting Standards (CAS) but dual listed companies (e.g. listed in both HK and China) continue to disclose their financials under the International Financial Reporting Standards (IFRS). In the past few years, Chinese regulators have been pushing local standards to international ones. After much revisions, the current Chinese Accounting Standards is very similar to the international standards. Only a few areas are different such as the accounting treatment on fixed assets: China uses cost basis whereas international standards use the re-evaluating method.¹

The reporting cycle for China A companies is on quarterly basis, the same or more frequent than international standards.² In the US and HK, companies are required to report financials on a quarterly and semi-annual basis respectively. I believe China A company reporting, given that it provides frequent and adequate financial data, is ideal for quant investing.

Note: 1. Chinese Accounting Standards (CAS), 2. International Financial Reporting Standards (IFRS). Source: PWC, Hongda China

How does your team account for the different auditing standards? How do you evaluate and analyze company’s management and corporate governance?

We have a team of 15 analysts and 15 portfolio managers in Shenzhen. Their local knowledge helps us value the companies on the ground more accurately. Beyond looking at Bloomberg financials, we perform our own analysis of financial data. We find asset-heavy industries with significant fixed assets such as land, property and equipment require the most work when adjusting valuations.

The advantage of having a local team is that we can visit the companies, do some ground checks, factory visits, and talk to different layers of management (e.g. engineers, CFOs, CEOs).  At the same time, our joint venture (JV) in Shenzhen gives us access to a wide pool of industry experts from different sectors ranging from healthcare, property through to technology, gathering their insights, talking to the company’s competitors, upstream suppliers and downstream customers.

What are Chinese regulators doing to increase oversight on China’s auditing practices? How will increased regulation impact the investment climate?

There have been significant reforms to tighten regulation of poor corporate governance in China. In the past, the threshold to get listed on the China A market was high (e.g. three years of revenue/profit growth) but the subsequent performance of the company was less governed.

The China Securities Regulatory Commission (CSRC) recently launched a registration-based IPO system, akin to foreign equity markets.³ The listing requirements would be lower but on-going regulation of companies after listing would be tighter. That means companies that exhibit poor corporate governance would see their valuations deteriorate and be forced into delisting. We are already seeing share prices of those companies falling sharply and regulators are delisting them as the market shifts to reflect fundamentals.⁴

What are the consequences of having poor quality data?

If you do not have access to quality data, it is difficult to identify companies with problematic cash flows, poor management and other issues. In Shenzhen, we have a “landmine cleaning team” that consists of portfolio managers and analysts with strong experience in accounting to go over potential buys and identify any suspicious data points in company financials. Our research process emphasizes on cash flow management, asset quality and corporate governance to avoid stepping on a “landmine’ company with poor corporate governance, where if triggered, produces zero value or no funds to repatriate to investors. For example, many fund houses were victims of a recent scandal involving a few healthcare companies and were holding those shares, but our JV avoided buying those companies.

What are some ways investors can invest in Chinese companies while lacking access to full corporate data?

For foreign investors, the main challenge is the language barrier. On Bloomberg, what is available is usually the English translated version of public announcements which may not be complete. The best way is to find a local research partner to help check data on the ground. Not every piece of information is written — it’s the hundreds of conversations face-to-face with different industry experts, analysts, competitors, upstream and downstream suppliers in the value chain that often provide valuable information about a company.

Stay tuned for the next issue of China, Explained, where we explore the most frequently-asked questions about investing in China.

_{Investment risks}

_{The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.}

_{When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.}

_{Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.}

_{1 Hawskford. Chinese Accounting vs. International Financial Reporting Standards: What Are the Main Differences?  https://www.hawksford.com/knowledge-hub/china-business-guides/chinese-accounting-standards-vs-ifrs}

_{2 Taiwan Economic Journal. China Financial Report. http://www.finasia.biz/tejonline/doc/ecn/ecnffin.htm}

_{3 China Daily. China unveils measures for registration-based system of ChiNext. https://www.chinadaily.com.cn/a/202006/15/WS5ee71e53a310834817253200.html}

_{4 Business Standard. China to delist record number of firms to ensure 'survival of the fittest'. https://www.business-standard.com/article/international/china-to-delist-record-number-of-firms-to-ensure-survival-of-the-fittest-120071500861_1.html}

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C2020-10-078

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