It’s 10.27am on a rain-drenched morning in mid-June, less than two weeks before the handover of Hong Kong to China. It is the annual general meeting of a China-backed company in one of the territory’s top hotels.
The company is a record-breaker. When it listed in 1993 it locked up a staggering HK$240 billion ($31 billion) of investors’ money – more than all the notes and coins in circulation in the former colony, now a special administrative region of China.
In fact ever since it was listed the company has traded below its issue price. Principally a manufacturer of cars, it is currently producing just enough to keep its factory in Guangzhou open. Last year’s losses soared 144%. Its joint venture partner, Peugeot of France, has pulled out. Are there furious investors barracking directors? How many hours will the AGM last? These are the questions Euromoney puts to a spokesman for Denway Investments as we wait outside.
He barely has time to answer. The AGM is over in 11 minutes. The whole thing is conducted in Cantonese. About 20 investors are there. When the company’s vice-chairman, Guo Peinan, is later asked by journalists about the break-up of the joint venture, he replies that several foreign car firms are looking to replace Peugeot. “But we will need to get the approval of Beijing,” he adds, “And this is another uncontrollable factor for us.” A loss for the year, says Guo, is “inevitable”.
Welcome to the world of Chinese corporate governance.
Elsewhere in Hong Kong’s corporate firmament, these China-backed companies are booming. The boom’s initiator is Shanghai Industrial, which listed in May last year, and is 65% owned by the Shanghai Municipal government. It is trading at well over six times its initial launch price of HK$7.28 – a price chosen for its auspicious feng shui (traditional Chinese symbolism). But even here the proverb “China is like a deep weir pool” is pertinent.
Incentives you can’t keep
Shanghai Industrial’s share option scheme is best described as a share option scheme with Chinese characteristics. The company’s chairman, Cai Lai Xing, has 4 million options exercisable at HK$8.08, and given the current price of HK$42.20 that means he is sitting on a paper profit of US$17 million. However, Shanghai Industrial’s spokesman says the money is not really his and he can’t “retire tomorrow on his windfall”. He adds: “Chairman Cai was appointed by the government, and according to our practice quite a large percentage of the money will be channelled back to the government or into the company.” This will be done according to a secret formula – and by definition, being secret, it’s not in the annual report.
Cai’s remuneration is a mystery. As is the reason for granting a manager share options as incentives and then taking back a good chunk of the proceeds if they go into the money. “[On] that point I can’t argue with you,” says the spokesperson, “but it is the practice of all China-backed companies.”
Shanghai Industrial is the best starting point for looking at the recent red-chip phenomenon that has swept Hong Kong in 1997, if only because it started it off. Owned substantially by the Shanghai municipal government, it is like all red chips a Chinese government-owned entity, but it operates under Hong Kong laws and is Hong Kong-listed. Such companies have been able to grow at a phenomenal pace through the so-called “injection” of assets onto the balance sheet, mostly from the mainland by their parent companies – usually a government ministry or muncipality.
For many of these companies it is a rags-to-riches story. When it listed last year Shanghai Industrial had a market capitalization of only HK$1 billion. One year later, in May 1997, that figure jumped to HK$38.7 billion. That makes it one of Hong Kong’s biggest companies, almost equal in size to airline Cathay Pacific (HK$40 billion) and old trading conglomerate Wheelock (HK$40.2 billion). But in six months’ time, the bets are it will be substantially bigger than both.
The company has achieved such remarkable growth by raising equity capital in Hong Kong, and buying assets in Shanghai such as roads, shopping centres, a cosmetics company and a food company. Something approaching alchemy is at work. A quick glance at the price earnings ratios readily explains all. The Shanghai-based assets are being bought at a P/E ratio of about 10. Shanghai Industrial carries a historical P/E ratio that is about five times this figure. So the company is following a classic route: buy cheap, sell high.
This arbitrage between how Hong Kong values China assets, and how Chinese officials do, has driven investors wild, and opened the way for other China-backed conglomerates. Suddenly Hong Kong’s stock market is going red. There are 54 red chips and the statistics about them beggar belief. One of the largest, China Merchant International began the year with a share price of HK$3.17. By mid-June it was HK$19.35. Jardine Fleming calculates that these companies are trading at a 134% premium to blue chips – on the basis of their respective P/E ratios. And most important of all seven red chips now number among Hong Kong’s top 40 companies by market capitalization, against three in 1993.
Corporate Hong Kong is in the midst of a shake-up. Red chips now make up almost 10% of Hong Kong’s total market capitalization, against less than 1% at the beginning of the 1990s. A new red-chip index was launched in June to run parallel with the more sober Hang Seng. The red chip index has a base value of 1000 for January 1993. It was trading at around the 3000 mark towards the end of June.
One of the most thrusting red chips, China Everbright IHK, owned by the all-powerful State Council, is currently trading on a historical P/E ratio in excess of 1100. This must be close to a world record. Theoretically it means it will take well over a thousand years at 1996 earnings to accumulate enough turnover to equal the company’s present market capitalization. The Hang Seng Index typically trades on a P/E ratio of 15.
Volumes are surging. On June 20 a record HK$26 billion of Hong Kong stock was traded. In April the average was closer to HK$6 billion. This was driven by the red chips.
A mania mentality is at work, says Marc Faber – alias Dr Doom – of Marc Faber Limited. “Imagine a scene where a man goes to a deserted frozen lake,” says Faber. “There is no-one around and he is cautious. So he cautiously prods the ice with his foot to see if it is thick enough to walk on. But if he arrives and sees a whole village having a Christmas party on the ice he will cross without caution. But actually the likelihood of the ice breaking when more people are on it, is greater.”
One US investor Euromoney interviewed admitted buying a red chip of which he knew nothing save its stock number. He sold it just hours before trading in it was suspended.
The mania element follows in a long and proud tradition that has its origins in the 18th century with the South Sea Bubble. No matter how strong the intellect, it is clear that no individual is above a mania. Even the father of gravity, Sir Isaac Newton lost a fortune on the South Sea catastrophe. “I can calculate the motions of the heavenly bodies, but not the madness of people,” he said at the time.
Of course, bankers and journalists love the red chips because of their deal flow. There are initial public offers – at a rate of nearly one a month – and plenty of secondary share placements. Some of these companies will be the dominant source of business for Hong Kong bankers over the next 10 years – and will establish themselves as the new hongs, supplanting the old trading-house founders of Hong Kong such as Jardine Matheson.
The names of companies predicted to dominate include Shanghai Industrial, China Overseas Land, China Resources, Guandong Investment, China Everbright, China Travel and of course, Citic Pacific, and Beijing Enterprises.
Charles Cheung of Jardine Fleming views the trend as strikingly similar to the growth of the Hong Kong Chinese families in the 1970s. The likes of billionaire Li Ka Shing’s Cheung Kong and the Kwok’s Sun Hung Kai were initially viewed as speculative stocks too, and their price movements reflected that. In 1980, for example, Cheung Kong was outperforming the more stable growth of the Hang Seng index by nearly six times. “We believe,” says Cheung, “that the rise of the red-chip sector is a continuation of a trend which reflects the transition of the territory’s business world, from the early dominance of British conglomerates, to the rise of local Chinese companies in the 1970s, and now the rise of mainland companies as Hong Kong returns to its motherland.”
Sam Lau, head of the greater China investment team at Invesco, agrees. “Cheung Kong listed in 1972, and it has grown phenomenally since. Your play in red chips is very similar,” he says.
One key red chip, Citic Pacific, has long been viewed as Hong Kong’s post-1997 powerbroker. It has strategic stakes in key industries such as the airline (Cathay Pacific) and power (China Light & Power). It is one of the territory’s top 10 companies by market capitalization, and is almost identical in size to the old British hong Swire Pacific – its market capitalization having grown nearly 95 times in six years. Its net profits grew from HK$333 million in 1990 to HK$6.86 billion last year. Its boss, Larry Yung, is head of the Jockey Club, probably Hong Kong’s most important institutional post.
Mr Red Chip himself is Francis Leung, the co-founder of Hong Kong-based investment bank Peregrine. “Francis invented red chips,” says Peregrine co-founder and chairman, Philip Tose. And since Peregrine invented them, it should come as no surprise that the firm’s share of red-chip business has been enormous. Peregrine estimates that red-chip fundraising since 1994 has totalled US$8.2 billion, of which it has lead-managed 35% of the issues, either on a joint or sole basis.
Much of this can be put down to Leung whose network of relationships ensure strings of mandates. Rivals are complimentary about Leung’s abilities, and say he is a formidable opponent. “We only stand a chance of winning business if Francis is elsewhere in China and he sends one of his more junior staff,” laughs one banker. “The only advantage we have is that Francis can’t physically be everywhere at once,” he continues. Leung, 42, is by all accounts a workaholic, and does his best to be everywhere whenever he can. Rivals say he even reads prospectuses when he is on holiday. “He almost treats it as a hobby,” says one.
Rewards of hard work
His hard work has paid off. Leung automatically has a seat at many of the biggest and best red chips’ tables. He is a non-executive director at Guangzhou Investment, Shum Yip (the City of Shenzhen’s red-chip vehicle), Beijing Enterprises, Denway Investments, Shanghai Industrial, International Bank of Asia (part of China Everbright IHD’s portfolio), Stone Electronic Technology, and Oriental Metals Holdings.
His position as non-executive director is usually the result of his earlier involvement in their flotation. Peregrine was lead-manager, for example, on Shanghai Industrial’s IPO and Leung was given his seat after its successful launch. Peregrine then did both its share placements in November and April, along with Morgan Stanley and BZW, respectively. It also led Shum Yip’s IPO in February. It spun off GZI Transport from Guangzhou Investment in January. And of course it was lead-manager on one of the most talked about deals in recent Hong Kong history, Beijing Enterprises. Beijing Enterprises broke all records with an oversubscription rate of 1,276 times.
Punters had rushed into Beijing Enterprises knowing it was the capital city’s version of Shanghai Industrial – and that stock was up 471% on the year. In the grey market the price had already tripled. And though there was a great deal of criticism of how bookrunners Peregrine and Morgan Stanley could allow such oversubscription to happen, it was sold at a P/E ratio of 19.35, one of the highest in Hong Kong’s history. Based on the professional valuers, the net asset value of the company was US$1 per share. It was listed at HK$12.86.
Its success was partly due to the level of political support the deal received. The company’s boss is Hu Zhaguang, a vice-mayor of Beijing. The company has a portfolio of businesses that includes some McDonald’s outlets, a hotel, department stores, a brewery, a road, and concessions to operate the Great Wall of China. Merrill Lynch calculated the break-up value of Beijing Enterprises at HK$9.69 a share – this was some HK$45 off where it was eventually to peak. The stock reached HK$55 in early June. The gold-covered prospectus of Beijing Enterprises, complete with an etching of the Great Wall of China and a page for every day of the year, was probably not essential reading for the bulk of individuals, or even fund managers. It did contain some warnings, however. “The People’s Republic of China’s judiciary is relatively inexperienced in enforcing the laws that exist, leading to a higher than usual degree of uncertainty as to the outcome of any litigation,” went one.
However, it contains a few less explicit warnings. For example, how will investors’ new cash be invested? The biggest cash investment is to be made in the group’s hotel, the Jianguo, whose occupancy rate is falling. On closer examination the numbers get confusing. Page 129 says the occupancy rate (excluding the impact of renovations) fell between 1995 and 1996 from 88% to 85%. Page 100 refers to the same period and again excludes the effect of renovations. But it says that the 1995 rate was 84.5% and the 1996 rate was 84%. Which is correct?
For all those who have made money on Beijing Enterprises it hardly matters. But close examination of the numbers is a job that analysts need to do. Some investors complain that the analysts aren’t. There is also the problem of self-censorship among the analyst community. One analyst admitted this. “Usually I tell the good stories and if I hear a bad one, I phone my clients. But I don’t publish it.” It is no coincidence his firm has a strong corporate finance arm and is keen to win red-chip business. An analyst who published negative comments about the sale of a huge chunk of stock to Citic Pacific’s management later “resigned”. It’s not easy for analysts even when it comes to the fundamentals rather than the politics. “You have a conglomerate with different sectors in different places,” says Pan Ming of Nava Securities. “You’re supposed to be a property analyst, a bank analyst, etc.”
What do investors want? One thing is for an analyst to do some legwork and put a number on what the absolute value of, for example, Beijing Enterprises is. This would involve estimating how many assets the red-chip parent has, what sort of quality they are, how likely it is they will be “injected” with new assets. Part of the difficulty of this seemingly straightforward exercise is that the Beijing municipal government could inject almost anything in Beijing because ultimately it owns everything.
Nor is it easy for auditors.
The auditing business is fiercely competitive, and with red chips the firms often have a big job on their hands, especially with the various subsidiaries in China. “Prior to 1994 if you sent someone to audit the company it meant there was a fraud investigation going on,” says Anthony Wu, a partner at Ernst & Young. He led the audit team on Beijing Enterprises done after 1994.
Tommy Wong, a partner at Deloitte Touche, which recently merged with Kwan, Wong, Tan and Fong, audits 19 red chips, the most of any Hong Kong firm. He notes there are many problems. He remembers one management asking him if the audit would be ready in two days. He said more like two months. “You get a nice lunch at the beginning,” he says but the management gets so annoyed with your prying that by the end “you end up with a packed lunch”. If management get too annoyed they can employ another firm. If this is done during the listing stage, investors are none the wiser because the prospectus is finished by the successor firm and it doesn’t mention that the previous firm was fired. There is a little less scope for such fits of pique once the firm is listed. If the auditor is changed the management must give a reason at the AGM the following year.
In one case some accountants couldn’t work out what an item was. When they asked the management, it responded that it didn’t know either. It turned out someone had put it there to make sure everything added up to “an equilibrium”.
There is a Chinese saying: “If you do a lot, you make a lot of mistakes. If you do a little, you make fewer mistakes. If you don’t do anything, you don’t make any mistakes.”
Not surprisingly some fund managers want to see what they’re buying. One big investor visited a red-chip subsidiary recently and made his own mind up. The steel plant had 150,000 tonnes of annual capacity but was only 50% utilized. He asked what the management would use newly injected cash for. “‘To expand capacity’, and I said, you mean, expand productivity. But no, it turned out they wanted 300,000 tonnes of capacity. That’s the mentality – size for size’s sake, even though the price of steel didn’t warrant it.” Bankers are cautious. “I still think there is a leap-of-faith element,” says Paul Shang, head of investment banking at Lehman Brothers. The key, he emphasizes, is to look for the red chips with sound management. Roger Davis, chief executive of BZW Asia, agrees: “Clearly there are some tremendous companies here that will be major players. But bankers must foster relations with the right companies.”
Alan Smith, vice-chairman of CSFB Asia, also singles out management as their key concern. “If two or three people leave Swire Pacific you still have a lot of management talent. In red chips who are the good people, and what happens if they leave?”
Unravelling portfolios
The problem with too many red-chip companies is that more often than not the investor is buying a portfolio rather than a bona fide company. And unless the red-chip management go in and shake-up the state-owned enterprises now under their control, then they are no more than passive fund managers.
Hands-on managers are highly favoured. Frank Ning is among the most favoured, and bankers praise his style. The chief executive of China Resources, a beer-to-banking-to-property conglomerate owned by the ministry of foreign trade and economic cooperation, emphasizes the bridging role of his company. “Our business will be to introduce finance, management and technology into China. The theme of our annual report is bridges. We are trying to be a bridge.”
Ning, educated at the University of Pittsburgh, is also almost unique in introducing a share-option scheme that would stand up to criticism anywhere in the world. It contains a two- to three-year lock-up to prevent directors and managers cashing-in while the euphoria lasts – and walking away. Even after the lock-up ends only a fraction of the options can be exercised each year.
Many of the other share-option schemes are either badly thought out or immensely confusing. Take Guangzhou Investment Company. One director, Cai Hanxiang, possesses over a third of all the share options granted to the whole 11-man board. The chairman of the company, Zhang Bohua, has around a sixth of the amount that Cai has. A spokesman for Guangzhou Investment was asked why Cai had so many more options than either the chairman, or the general manager and vice-chairman, Guo Peinan. He appeared puzzled, and said he didn’t know the answer either.
The composition of the board says a good deal about where a red chip sees itself going. Citic’s board includes expatriates and holds meetings in English. China Resources has a board which is split 50/50 between those from outside and inside the People’s Republic of China. Others are filled with a host of party apparatchiks.
One of the most interesting is that of Silver Grant, a mining-to-property conglomerate. Its ownership links it to Beijing-based China National Nonferrous Metals, and also to China Construction Bank. The link to China Construction Bank is through four directors who on paper appear to own a third of the company themselves. According to Silver Grant they are nominees for China Construction Bank. However when Hang Seng Index Services drew up the new red-chip index Silver Grant was excluded. The people at Hang Seng refused to accept that the four directors were nominees, and so only counted the shareholding of China National Nonferrous which was less than 35%. To be a part of the index a company must be more than 35% mainland owned. All of which means that new red-chip index tracker funds won’t buy Silver Grant because it’s not in the index.
Non-executive directors are usually the great and the good of Hong Kong. For example, China Overseas Land has Bank of East Asia boss David Li as a board member. Shanghai Industrial has Sir Lee Quo Wei, the Hang Seng bank boss, on its board.
But even with the inclusion of such senior Hong Kongers, where does the power lie in these companies? In the Hong Kong boardrooms, or on the mainland? Who decides, for example, what assets should be injected? Bankers say they approach this most crucial of mandate-winning questions on a case-by-case basis. A triangular approach is most regularly adopted – schmoozing Hong Kong bosses, attempting to visit mainland bosses such as local mayors, and seeing whoever they can in Beijing.
At Guangzhou Investment, for example, the Hong Kong-listed company’s board meetings are held alternately in the territory and in Guangzhou. Following the meeting after Chinese New Year the board formally meets the mayor. Whenever there are officials from the city visiting Hong Kong, the company arranges meetings, a hotel and transport. And according to a spokesman, the company is quite wary about making statements that directly veer from company policy on to anything that is too general about China. In cases where the state of China might be necessary – such as in the annual report – statements are passed to Beijing’s mouthpiece in Hong Kong, the Xinhua news agency for comments.
Guangzhou’s parent, Yue Xiu, is owned by the municipal government. Its corporate brochure offers a brief glimpse of its history. “The new board of directors, formed in 1991, made use of the basic principle of philosophy and analyzed the situation in Hong Kong critically. They understood that both opportunities and challenges coexisted in the market economy of a capitalistic society. An entrepreneur not only has to foresee the favourable and adverse conditions, analyze strengths and weaknesses, but also make objective, unbiased judgements, adapt to new changes, make appropriate adjustments and turn bad to good situation.”
China Travel International Investment makes a point of emphasizing its Hong Kong locale. Its managing director, Michael Ng formerly worked with Hong Kong tycoon Sir Gordon Wu and personally negotiates with the parent company on the injection of assets. He managed to persuade it to sell the Metropole Hotel in Hong Kong at a 45% discount to its net asset value. Similarly he bought the Window on the World theme park in China at a P/E ratio of 6.5 times – he says he negotiated it down from nine.
But what does this mean? It means negotiating with his own chairman. He does not deny that the parent has an effect on the strategy, although when, for example, it wanted to inject an electronics firm he refused because it did not comply with his strategy for the listed company.
“I don’t sit on the board of the holding company,” says Ng. “But the major characters are common directors, all based in Hong Kong. We have constant communication. But if there is a huge investment we have to get the permission of the State Council.”
It is important for the senior man in the red chip to have clout. Zhu Xiaohua, head of the State Council-backed China Everbright Group, has made his mark since joining last summer.
He graduated in the early 1980s from the Shanghai Institute of Economics and Finance, and was fast-streamed into the People’s Bank of China. He later spent a year with the IMF in the US, before promotion, first as a deputy governor of the central bank in Beijing, then as head of the State Administration of Exchange Control, which has a deputy ministerial rank. Unfortunately his department took some flak for failing to prevent hot money entering China during the inflationary period of 1994. He resigned his post in late 1995 but still kept his job as a deputy governor of the People’s Bank.
He was then put in charge of China Everbright Group in mid-1996. He chairs everything within the company – both at the parent level (the part that owns the assets to be injected) and listed level (into which the assets are injected). He speaks and reads English.
Before he arrived, the red chips attached to the Rmb80 billion (US$10 billion) group lacked direction. For example, Everbright took a HK$141 million hit for an investment in an insurance company whose assets can’t now be located. Since then a flurry of activity has led to huge hikes in the share prices of all three Hong Kong red chips under his stewardship. His success in injecting 20% of Everbright Bank into China Everbright IHD was a personal triumph, as it puts the company on a sound strategic footing as China’s financial red chip. His relationship with Zhu Rongji, China’s economic tsar – whom he knew when he was Shanghai’s mayor – is widely regarded as playing an important role in getting the deal approved. He is known as a Zhu protégé.
Worries about regulation
There are worries that China is selling off its assets too cheaply, particularly inside China. However as Cheong Long, ING Barings’ red-chip analyst puts it: “When you sell a power plant to a red chip at $100 million and that company raises $100 million [in equity capital], the share price goes up 50%. As the major shareholder, you sold something cheaply but made it back in the share price appreciation.”
“The red-chip phenomenon is a fairly effective way of channelling capital into the development of the PRC,” says Kevin Westley, head of HSBC Investment Bank. But there are still concerns. Hardly a day goes by without rumours of China’s regulator intervening to spoil the party. Anthony Neoh, the head of Hong Kong’s Securities and Futures Commission does not seem overly worried. He visited the head of the CSRC (China Securities and Regulatory Commission), Zhou Daojiong on June 2 and resolved quite a few issues over “a beer and some dinner”. A key issue discussed was disclosure.
This is one of the most serious issues regarding the red chips. The handling of market-sensitive information is generally botched. Silver Grant, for example, was recently rapped over the knuckles because of a brochure sent to retailers in Hong Kong to persuade them to take space in a new shopping mall in China. The brochure contravened stock exchange rules by forecasting the company’s profits would grow by 20% this year. In fact, predictions are only permitted when a company lists, and that prediction is only for the year going forward.
Silver Grant disassociated itself from the brochure. It said it was produced by its joint venture partner in China, and told the stock exchange that it was riddled with inaccuracy, such as stating the 1996 profit was HK$100 million when it was HK$139 million. It gave an undertaking no such thing would recur.
A still bigger problem is the rumours that surround asset injections. “The companies would not dare to say anything for fear that an announcement would appear to put pressure on the approving departments in China,” says Neoh, who suspended 12 red chips from trading between mid-May and mid-June. “Some went so far as to suggest it might be a breach of state secrets.”
Neoh says Zhou understood immediately. A pragmatic solution was arrived at. If the company is now asked about a rumour, and there are grounds for its circulation, it can say an injection is being considered so long as it also states that an approval may not necessarily be given.
Neoh doesn’t foresee a conflict with the CSRC over regulation. “As a practical issue they don’t have the resources to do it even if they wanted to. They have a big market to regulate and they don’t have as many people as I do. They have 150. I have 280. Besides they would not tamper with Hong Kong regulation which is based on long-standing predictable principles. They regard Hong Kong as being very well regulated and hopefully feel very comfortable with me and my staff.”
Some say more of an issue is the way in which the red chips are turning Hong Kong into two markets with two tiers of regulation. There is the normal market, and there is the red-chip market, which looks, walks and talks like an emerging market. The recent suspension of China Everbright IHD exposed the problem.
It attempted to raise 20% of its equity capital in new shares, stating it was doing so to bolster its “working capital”. This was perfectly legal under company law. However the stock exchange and the ƒ wanted to know why it was raising the money. If Swire Pacific, or an established Hong Kong company, had tried to raise 20% of it equity, giving the same reason, no questions would have been asked.
So is it one rule for hongs, another for red chips? “We apply the same rules to everybody,” says Neoh, “but the results come out differently. You don’t have the same volatility in Swires, and its corporate history is well known. A red chip company has very little corporate history and in fact may have changed drastically from being a small company in just a year. My rule is there has to be an informed market. So therefore applying the same rules you come out of the wash with a different set of results.”
