SCMP, 27 July 2013,

http://www.scmp.com/comment/insight-opinion/article/1291453/why-chinese-stocks-perform-poorly

Summary:

(1) They had cooked books before IPO, often with the assistance of local governments,

(2) They engaged in bad business practices,

(3) They sold too many new shares,

(4) They suffered cost explosion as inflation surged.

China's equity market has been around for 20 years, and its performance has been very disappointing. Since its birth in 1994, the Hang Seng China Enterprises, the so-called H-share index, has gone up only 44 per cent, though the Chinese gross domestic product has grown almost tenfold in nominal terms. So why the huge discrepancy?

Having worked for years as a research analyst, I have some thoughts about this seemingly strange phenomenon.

First, a large number of listed Chinese companies cooked their books just before their initial public offerings, sometimes assisted by local governments. Of course, the fake elements could not grow indefinitely, unlike revenues or profits. This has led to a prolonged period of unnaturally slower growth and even a decline of net profits after their IPOs.

Just before they went public, some companies received "support" from parent companies or controlling shareholders. This came in many forms, such as parent firms taking over from the IPO companies a bloated workforce and/or expenses (even expenses related to the IPO), or through the purchasing of the products from the IPO companies at higher prices, and the selling of input (or raw materials) to the IPO companies at unfair prices.

Special assistance also included low-interest loans, and restructuring, such as the "supporters" taking over failing business units at sweetheart prices.

Local governments even mobilise their tax departments to assist IPO companies. They also give cheap land to these companies or allow them more lenient environmental standards. "Asset injections" are another form of assistance from controlling shareholders that fool minority investors, as these are neither organic nor sustainable. The list is long.

Clearly, all these forms of assistance are one-off in nature and cannot grow the way revenues and profits grow. Their net effect is to inflate IPO prices, and raise investors' expectations.

Strangely, in mainland China and Hong Kong, these IPO companies and their parents do not always try to hide these things, and even brag about them. More bizarrely, regulators do not often pursue these obvious cheats. Look at the annual reports of listed companies, and you will see what I mean. Of course, there are many cases of special assistance that the listed companies do not want us to know about. And some of those practices are blatantly illegal, including hiding transfer payments to inflate the historical numbers of IPO companies and simply cooking the books.

With the IPO proceeds safely in the bag, however, the listed companies may use their lower subsequent growth to wash away some of the inflation they had planted before the IPO.

The end result? A strong economy, a less strong corporate profit, and a still-weaker stock performance.

Another reason for the poor performance of China's stocks can be seen by taking a cue from Warren Buffett. Looking at the movement of the Dow Jones industrial average from 1964 to 1981 (17 years) and then from 1981 to 1998 (another 17 years), Buffett concluded that, in the long-term, what matters most to equity valuation is interest rate, i.e., inflation. His idea can also help us shed light on the weak performance of China's stocks in the past 20 years, particularly the A-share market.

In an essay, "How Inflation Swindles Equity Investors", Buffett illustrated that, contrary to common perceptions, inflation hurts both businesses (mostly through rising input costs) and their valuations (through a higher discount rate).

In China, where H-share companies operate, high inflation has lasted more than two decades. In Hong Kong, where these H-shares are traded, inflation has been high too, but as the Hong Kong dollar is pegged to the US dollar, inflation in Hong Kong does not reveal itself in higher interest rates, so it's not an issue for the valuation of H-shares. Therefore, the poor performance of H-shares mainly reflects a disappearance of the China "scarcity premium" that foreign investors had assigned to H-share companies in the past, plus a current cyclical downturn of the economy.

There are other important reasons for the weak showing of China's stocks (both H-shares and A-shares):

• Managers are often political appointees who are not there to maximise shareholder value
   
• Political interference in business hurts the continuity of management and corporate strategy
   
• The lack of accountability on the part of the management means that expenses often run out of control
   
• Chinese companies are too eager to issue new shares to finance questionable expansions, instead of making their existing capital work harder. So their returns on equity lag behind their US counterparts.

It has taken us nearly 20 years to learn these lessons. Now let's see what we learn from the future of China's H-shares market.

Joe Zhang, the author of Inside China's Shadow Banking: The Next Subprime Crisis?, is an independent corporate adviser in Hong Kong.