The Motley Fool

Could China’s SOE Reforms Spark a Rally in 2019?

After years of mediocre stock price performance, Chinese SOEs may finally see a much-needed rally in 2019. SOEs account for over half of the market cap of the China A-shares market, and also account for seven out of the top ten largest companies on the Hong Kong Stock Exchange by “free-float adjustment” market cap.

Why SOEs need to reform

China’s state-run companies have lagged in stock price performance since the global financial crisis. From March 2008-18, state-owned companies from the MSCI China index returned an average of just 2.25% a year, compared to 13.51% for non-state-owned companies.

The average return on equity for non-financial state-owned enterprises dropped from 15.6% in 2007 to around 7% in 2017, compared to 8% for non-state-owned-enterprises. The global financial crisis forced many SOEs to over-invest in their respective sectors and stimulated the economy, leading to lower ROI projects and swollen debt levels.

Now China needs to spur private sector growth to drive the economy, and in March the government announced that it would be lowering the country’s value-added tax rates by 3% to do so.

In order to make up for the lost tax revenues, the central government will have to facilitate growth at its inefficient SOEs. China VAT revenues accounted for a whopping 32% of the central government’s revenues in 2015.

China advances mixed-ownership reforms for SOEs

Enacting mixed-ownership reform for SOEs is one initiative the government is taking to improve profits. In March the government announced that the private sector would be allowed to hold a controlling stake in state-owned enterprises (SOEs). Previously, they were only allowed to own minority stakes.

Challenges Remain

And yet many challenges remain, despite the prospect of private sector companies and investors taking a more substantial stake in China’s SOEs.

Frequently the interests of the state are placed ahead of traditional business objectives. This could mean maintaining local employment numbers or other interests. Their goal isn’t always to grow revenues or stock prices.

For example, utility companies may have a limit on how high they can hike rates because they have to serve poor consumers no matter what. Other underperforming SOEs could be ordered not to cull excess labor capacity because there’s a lack of private sector jobs to absorb laid-off workers.

One major example was China Unicom selling a 35.2% stake to Baidu, Alibaba, Tencent, and a few other technology companies in 2017. China Unicom is one of China’s largest telecom companies, and together with China Mobile and China Telecom, the three dominate the sector in China.

The share sale raised $12 billion in proceeds; Baidu, Alibaba, and Tencent were each given board seats, with many observers hoping that this would be a step towards improving operational efficiency.

Secondly, the state council appoints manager in charge, not a board of directors consisting of private shareholders, and are often rotated to different companies so that they are less likely to build a power base that could lead to nepotism or corruption.

This means that they may not be competent in their line of work and are chosen solely for their loyalty to the party. Many executives even become government officials after leaving their respective industries.

Lastly, managers’ compensations are not directly tied to the performance of their companies or stock prices. Chinese state-owned enterprises are forbidden from awarding stock options and equity to their executives, who are often paid just a fraction of their peers’ salaries at Western multinationals.

Because of these reasons, many Chinese SOEs have seen their share prices lag their private sector peers over the last few years and are now trading at a discount. Now maybe the time to buy their shares, though investors should keep a close eye on any policy announcements relating to SOE reforms going forward.

Like many other world indexes, the Hang Seng has changed drastically over the years. One thing that has remain consistent is its incredible long-run performance. Real estate often gets the headlines in Hong Kong, but it might surprise you to know that the Hang Seng has not only outperformed HK real estate over the long run, but the margin is meaningful. I detail all that and much more in a new special report I’ve put together, “The 4 Rules for Winning in the Stock Market: A Foolish Guide for Hong Kong Investors.

Click here to download a free copy right now!

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Ker Zheng doesn't own any shares mentioned above.