No home for China shares in a fair-priced portfolio
The year to June witnessed enormous variation in sharemarket returns. The Australian All Ordinaries Index recorded a miserly 1.3 per cent return, excluding dividends. The Shanghai Composite Index was easily the best performing major market with a return of 108.8 per cent.
That excitement, which saw the Chinese market up 152 per cent at its peak, was driven by a lot of leverage (that is, investors borrowing to finance their share investments). There are plenty of individual shares selling on nose-bleeding multiples.
The 30 per cent decline in the past month has seen $3.2 trillion of value, or more than two times the total value of the Australian sharemarket, wiped out. Given most small Chinese investors who undertake margin lending joined the market near its peak, there is a fear this decline will transmit into the real economy.
Making matters worse, about one-quarter of the companies, representing one third of the market capitalisation (and listed on the main exchanges in Shanghai and Shenzhen) have had their stock suspended, something usually reserved for significant imminent announcements.
Surety needed in investment
The “risk off” bet (the decision of many Chinese investors to sell at the same time) has translated into a recent sharp decline in iron ore, down 26 per cent to about $US45/tonne; crude oil, down 12 per cent to $52/barrel and copper, down 7 per cent to $2.44/lb.
The objective of the Montgomery Global Fund is to find a handful of high-quality companies, with good prospects at a discount to their estimated intrinsic value, and if there are insufficient companies that appeal, then we allow the cash component of the portfolio to build.
To run such a fund you need to be absolutely sure of the numbers that you work with. Excess volatility also does not make the job any easier. Some investors will take heart at the ‘rebound’ we saw at the end of the week in the Chinese share market with a 6 per cent jump in a single session.
But the Montgomery Global Fund does not, and is unlikely to own, any Chinese-listed companies.
The issue I have is one of transparency and that has a lot to do with the audit process and the hurdles foreign auditors face when trying to assess Chinese companies. Such financial and business information has been categorised by the Chinese government as state secrets, so cannot be turned over to foreigners.
The “big four” auditing firms do not operate in mainland China. Instead, they essentially license their brand name to local affiliates. Under US law, all major auditors must undergo regular inspections by the Public Company Accounting Oversight Board (PCAOB).
Yet the PCAOB is not allowed by the Chinese government to inspect the local Chinese affiliates of the big four auditing firms. It cites national security reasons. Therefore, all US-listed Chinese firms appear to be in breach of the Securities Exchange Act.
SEC caves in
The Securities and Exchange Commission, however, basically has caved in to Beijing’s refusal to turn over such corporate information to US regulators. The SEC had the right to de-list all Chinese companies from US exchanges for being in breach of the Securities Exchange Act. It chose not to.
Chinese accounting expert Paul Gillis, from the Guanghua School of Management at Peking University, sums up the situation nicely: “Today we have different rules for Chinese companies that list in the US than we have for others. Not only is the SEC dependent on Chinese regulators to decide what documents they can see, the PCAOB remains unable to conduct inspections of auditors.”
In Australia, we have the Corporations Act 2001, which sets out the laws dealing with companies in Australia. Section 310 of the act states: “The auditor: (a) has a right of access at all reasonable times to the books of the company, registered scheme or disclosing entity; and (b) may require any officer to give the auditor information, explanations or other assistance for the purposes of the audit or review.”
So what would an Australian auditor do if it were faced with the task of auditing a Chinese company?
Of course there are always opportunities in China, but there are safer ways of playing the growing middle class – and you don’t need to suffer the knee-trembling volatility or poor transparency of investing directly into a Chinese-listed company.
Roger Montgomery is the founder and Chief Investment Officer of Montgomery Investment Management. To invest with Montgomery domestically and globally, find out more.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
Ben
:
Does the auditing issue affect Seek’s Zhaopin business?
Patrick Poke
:
I’m curious what what your view is on HK listed mainland companies? The prices are generally a lot lower than the mainland (average PE on the HK main board is 9.83 times as at yesterday), and HK market does not suffer from many of the same issues as Shanghai/Shenzhen. If the Global Fund located a quality company at an attractive price on the HK board would you be hesitant to buy based on its listing?
I had previously been a holding of SBB and after reading the posts about Australian listed Chinese companies, I attempted to clarify the auditing procedures directly with the company. I had made multiple contacts with their investor relations person, who had forwarded my questions to both the company and the auditor, but after weeks of follow ups I received no response. Having lost faith in the company I decided to sell at a large loss; painful, but better than losing all my capital in the event that there did turn out to be major flaws in the company’s auditing. I had done as much due diligence on the company’s books as I was capable of (the only ‘red flag’ I identified was unusually large gross profit margins with no identifiable explanation for them), but checking the books is not worth much if you’re unsure if what’s in them is accurate.
David Buckland
:
Hi Patrick, the Montgomery Global Fund and Montaka are prepared to own Hong Kong listed companies. One example is PICC Property & Casualty Co Ltd (2328 HK).