Janus Henderson: China investing part 4 - board oversight

​‘A fox may preach religion, but it still intends to steal chickens’

 Judge intentions by actions, not words – Chinese proverb

In all markets, good corporate governance starts with the board of directors. In China, however, there are a number of indicators to look out for when evaluating governance and the board’s composition often provides an insight into the mind of a company’s ultimate controlling shareholder. In our review of over 50 companies in the ‘Signals and Smokescreens’ study, over three quarters exhibited red flags that might indicate poor alignment between the interests of the controlling shareholders and minority public investors.

Transitioning from planned economy to market economy

China is experiencing a transition from a planned economy to one in which market forces play a much greater role. Consequently, companies that have developed in the nascent private sector have relatively short histories and consequently share ownership often remains concentrated in the hands of the founding management team.For example, in one public company we reviewed, block ownership by the controlling shareholder was over 80% of the issued share capital. Given the total control that flows from this degree of ownership, minority investors need strong reassurance that the controlling shareholders will always act in the interest of all shareholders. The purpose of this section of the study is to help investors interpret, using publically available information, the mindset of a company’s ultimate controller and their attitude to strong governance and internal controls.

Board construction

The ‘Signals and Smokescreens’ study found consistent key indicators that help investors assess the real intentions of the controlling shareholders as they construct the boards of public companies. Some companies have a diversity of experienced directors that shows a real desire to implement the proper governance standards and internal controls that are needed to build shareholder value over the longer term.

Others are stacked with insiders who lack the interest or authority to protect the rights and interests of minority shareholders, and this may indicate a short-term desire from the controlling shareholders to take as much value out of the company as possible.

Warning signals

Examples of companies with signs that controlling shareholders are not prioritising the long-term interests of all of the shareholders included situations where the boards had some of the following characteristics:

• Family-firsters – some company boards are dominated by family members of the founding management team; one consisted of two brothers, plus their brother-in-law, with no experienced independent directors. In another case of a quoted Hong Kong company, the chairman appointed her 21-year old son as an independent director. There are also plenty of examples where family-run companies have genuinely independent, competent non-executive directors and this gives a high degree of comfort that the founders want to do the right thing and build value over the longer term for the benefit of all shareholders.

• Vase-directors – this term refers to appointments that are more decorative than functional, often consisting of esteemed scholars and learned academics, who have little or no corporate or business experience and are thus unlikely to detect and prevent governance failures. In one particularly high-profile fraud, after one of the non-executive directors was fined for his failure to intervene, he protested publically that he should not be punished because he ‘always regarded the independent directorship as an honorary title’, ‘knew nothing about the operation of the company’ and ‘did not have the ability to understand the accounting sheets’. The appointment of such ‘vases’ implies that the controlling shareholders are keen to avoid proper scrutiny on behalf of minority shareholders.

• Musical chairmen – sometimes there is an astonishingly high turnover of directors and executive staff. This is by far the most prevalent red flag observed in underperforming or fraudulent Chinese companies. Multiple resignations of board members or dismissal of executives indicates tensions at a management and board level and suggests that individuals could be leaving as a result of discomfort relating to its operations and/or financial reporting. One company we reviewed saw five chairmen in the space of three years, whereas another saw 9 resignations from the board within a period of one year.

• Impulsive strategists – other companies have chairmen who impulsively make up business strategy as they go along, implying that there is no proper internal review process by a competent board. Examples include a quoted business that manufactured LED lighting in southern China, which suddenly acquired a second tier French football club. The chairman of the company, interviewed after the announcement, said in a somewhat unguarded moment that he had initially been against the acquisition because he “didn’t know anything about the football business,” but changed his mind because “President Xi wants to promote football in China so it’s a good relationship crossover”.

• Un-Chinese characters – appointment of a director or CFO who has no experience in China, no presence in China or who cannot read Chinese characters. This type of appointment has been made at numerous high-profile cases of major fraud in Chinese companies where management took advantage of the information asymmetry this presented, using it as an opportunity to pull the wool over the eyes of foreign directors and, in particular, CFOs who could not read Chinese. There is no reason why shareholders should not ask the directors and management at the AGM whether or not they can read Chinese, but this very rarely happens.

• Prior record – reputation is often the best judge of a person’s character and competence. It is therefore very revealing of the intentions of controlling shareholders when they appoint individuals to the board who have either been intimately involved in or associated with corporate scandals. In an examination of one NYSE-listed company, we found that the controlling shareholder had appointed an individual as director and chairman of the audit committee who had previously been the CFO of a NASDAQ-listed company that collapsed spectacularly after allegations of fraud, wiping out over US$1 billion in shareholder value. This would have been revealed by a rudimentary desk-analysis of the internet.

Positive attributes

On a positive note, we have found Chinese stocks that performed robustly under conditions of financial stress, such as a short-attack*, where a diverse and properly experienced Board was able to ‘circle the wagons’ and mount a prompt, coherent and decisive response for the protection of shareholder value.We particularly noted one Chinese software company that suffered a sustained short attack, but eventually emerged from the ordeal with its stock price intact. The board consisted, not only of the core controlling management team, but also highly experienced corporate veterans from a variety of business backgrounds, including the former head of the Asian operations of a major investment bank and a representative of a large US-based institutional investor that had a substantial stock holding and remained firm. The inclusion of this level of expertise demonstrated that the controlling shareholders had not only appointed directors committed to the long-term success of the company, but who also had reputations to lose and would therefore be vigilant in enforcing good governance. We found this to be a clear sign that the controlling shareholders viewed their interests as aligned with those of minority shareholders because it implied that they both had nothing to hide and were willing to prove it.

Summary

The key question here is:
What signs are present to help investors understand the mindset of the individuals who ultimately control the company and to assess the proper alignment of the interests of all shareholders through good governance?

The table below shows the flags that were most instructive in our analysis.

Investment team perspectives

Charlie Awdry, China equities investment manager at Janus Henderson:
“Analysing the board of directors provides important insight into the culture and professionalism of a company. This is particularly important in China where strong leaders, family businesses and high levels of related party transactions are common.”Antony Marsden, Head of Governance and Responsible Investments at Janus Henderson:“Researching the background and track record of directors is a very time consuming task, but it can help reduce the chance of making a bad investment decision from the outset. A leopard can’t change its spots, and directors involved in corporate misconduct are frequently not first time offenders.''Note:

*In a short attack, firms conduct extensive desk analysis and on-the-ground due diligence of a listed company that they suspect of being either fraudulent or of manipulating their share price. After gathering their evidence, these firms take large short positions before publically releasing negative reports on the company in question in an effort to depress its share price and profit from their short positions.

Part 1: Janus Henderson: China investing - China-specific risk
Part 2: Janus Henderson: Risk, with Chinese characteristics
Part 3: Janus Henderson - China investing - financial ratios
Part 5: Janus Henderson - China investing - material and related-party transactions