Investing in Chinese companies on AIM

While more than 600 companies from Mainland China are listed on the Hong Kong Stock Exchange and another 350-plus are listed on various exchanges  in the US, the number of Chinese companies quoted on the London Stock Exchange (LSE) AIM market stands at just 43, down from a peak of 68 in 2008. The difference in the numbers is striking, not to mention the gap in market capitalisation. What makes London, a global financial centre, less attractive to Chinese companies seeking an overseas listing? 

While the debate on the above question warrants a lengthy research paper at least one of the key factors seems to be the less enthusiastic participation from UK investors. With this in mind, we have put together some Chinese stock suggestions derived from our own experience as well as our partners’ that can be applied  to spot good-value investment opportunities, with a further two companies being analysed for discussion. 

As a financial adviser, we work at the frontline of advising Chinese companies on their floating processes in London. We understand that while investors recognise the growth opportunities that Chinese companies can deliver, many are often put off by fraud allegations, and the recent storm in the US market has probably enforced such a view. 

Other concerns that investors may have include a lack of transparency in management, weaknesses in corporate governance, the potential of a delisting and perhaps a lack of information available in English. Admittedly, there is no magic formula to solve these issues, but we believe that certain steps can be taken in order to improve the odds of finding the right stocks, particularly for long-term investors.

Before going into details, some statistical research conducted by our team is worth examining. The 43 companies on AIM cover about 19 sectors out of a total of 41 often used to classify listed companies on the LSE, or 46 per cent. Not surprisingly, the most popular sectors are mining, electronic and electrical equipment, food producers and processors, and financial services, a reflection of London’s strong appeal to natural resources and finance- related listings.

The combined market capitalisation for these companies is roughly £3.4 billion as of 31 October 2011. Their market sizes vary, from Asian Citrus, an orange grower that has recently expanded into the fruit juice business and is valued at well over £450 million, to a few companies worth less than £5 million.

Stock prices remain very volatile.  For instance, the share price of Dongfang Shipbuilding rocketed from 20p to 117p following its introduction in August 2011, without any specific reason published so far. At the time of writing, however, a poor trading update has knocked more than 50 per cent off its share price, taking it down to around 45p.

Returning to the stock selection for Chinese companies, whereas numerous articles have written extensively about the economic and political elements in China, by contrast we believe analysing individual companies could yield better results than predicting what the government will or will not do. In the end, investors need to have belief in a management that is capable of handling all external events, including changes in government policies, on their behalf.

Who are the customers?

One way to avoid landing upon unpleasant accounting surprises is to look for companies that sell products or services directly to public consumers, or that have a large client base. 

This is an important idea in stock selection that often goes unnoticed. If a company sells to the public and has a track record of rising net profit, preferably three to five years minimum, then there is a good chance that a genuinely competitive ‘moat’ has been built around its business that attracts customers. Such characteristics would limit the possibility of the management over-booking revenues from one big ‘fanciful’ contract that never materialises, which is repeatedly considered to be a major concern when looking at Chinese businesses.

In addition, these characteristics are further indicators that the management has done something right in terms of exploiting open market forces – a demonstration of high managerial qualities. As a result, company officers are less likely to engage in under-table dealings, as they can see more incentives to improve profits from expanding the competitive advantages than spending energy on account manipulation. 

Having said that, investors should not automatically assume clean sheets for companies in this category. Furthermore, this is by no means to imply a less attractive investment on businesses that only sell to a small number of clients; their operations may well be shaped and constrained by the nature of the industry. 

What efforts have been made to communicate with shareholders?

Retail shareholders are passive partners and owners of a business, argued Warren Buffett and Benjamin Graham. A company that does not attempt to communicate with shareholders, i.e. its owners, is probably not the type of company that an investor should consider, even if it presents compelling statistics, especially as most Chinese companies operate in a business environment unfamiliar to UK investors.

On the other hand, these distinctive approaches in communication can assist investors in the search for good opportunities. For instance, companies should give careful consideration when selecting their advisory team. This includes teaming up with nominated advisers and auditors that provide the highest standard of service, as well as PR firms that enable effective communication between the company and other stakeholders. All these appointments are public information, so it is not a difficult exercise for investors to spot the differences and form a judgement on this matter.

Our research has found that few Chinese companies (ten out of 28) listed on AIM before 2008 have appointed a financial PR firm. On the contrary, more than 70 per cent (11 out of 15) of those that listed between 2008 and 2011 have done so. This is a clear indication that new arrivals are increasingly putting more effort into communicating with shareholders, and we believe that this trend is set to continue. Having said that, investors should take account of cases where companies are constrained by limited financial resources in implementing such measures.

Other characteristics

Investors are mainly rewarded for holding a stock through two sources: share price appreciation and dividend payouts. A consistent dividend distribution could compensate the downside risk associated with share price movements. We will use BlueStar SecuTech as a case to illustrate this point later. 

Also, companies that are leaders in their fields and operate in fragmented sectors often have great potential, and there are plenty of them in China, for example in agriculture, logistics and renewable energies. These sectors already enjoy a large aggregate market demand, and are poised for further consolidation, which presents financially strong companies with great expansion opportunities.  

Moving on to the stock watch for two Chinese companies, AIM-listed BlueStar SecuTech is a leading provider of ‘next-generation’ surveillance network solutions in China. It supplies digital video recorders (DVRs), equipment and networking services, mainly to the banking sector in China, and once had an 80 per cent market share in Beijing. 

Any investors who had taken a stake in the company at the start would wonder whether they had made a serious mistake – the share price has lost almost 70 per cent since 2007 , down from 48p to the current price of 12.75p, despite revenues having more than doubled over the same period. At the time of writing, a profit warning has been issued that caused its share price to fall by 14 per cent.

However, amid this backdrop, the company has a good record of paying dividends – an accumulated dividend of 3.08p has been distributed so far, equivalent to 5.3 per cent per annum over its current share price. This figure may not look impressive at first glance, but given that the dividend to net profit rate is only 20 per cent, its true earning is much higher than it appeared. In the year ending March 2011, BlueStar made a net profit of approximately £3.3 million, against a current market capitalisation of merely £10.6 million. This translates into a potential return on investment of more than 31 per cent . With a modest dividend policy, BlueStar has managed to build up a net current asset value of £24.2 million with little borrowings. 

More details are required before a full assessment can be carried out following this profit warning, though it was noted that orders for its products remained strong for the second half of 2011. Thus, the key question remains whether the management can turn things around quickly. All these developments lead to a cautious outlook for the company, but at the current share price and with a strong balance sheet, BlueStar could create a good buying opportunity.

Asian Citrus Holdings is a primary orange grower that recently expanded into the fruit juice business through a major acquisition in 2010. The company is dually listed in Hong Kong. Chart 2 shows the volability of its share price. The recent fall is due partly to the adverse market conditions, and partly to panic selling over its ties with a fertiliser supplier, Chaoda, that has been involved in fraud allegations. 

With a vertical expansion into fruit juice, more synergies should come from this acquisition in the coming years that provide further growth opportunities. In addition, the company’s backbone orange-growing division, which is still at a fast-developing stage, can give a high level of comfort. On a cautious note, investors should take account of the impact of possible changes in preferential tax rates that the company and its subsidiaries currently enjoy.

Investing in China and other emerging markets should always be considered as relatively high risk, but these risk factors have to be put into the context of possible large long-term gains. While the economic path for China is certain to be accompanied by periodic disruptions, the long-term fundamentals remain solid after decades of economic reforms and wealth creation. Given our belief that more high-quality Chinese companies will choose London for their listings, it is a good time for investors to start looking.

Ruiwen (Andy) Chen is an executive director at HanTime Capital whose previous posts include working for a Fortune 100 company in the UK. HanTime Capital is a leading financial advisory company advising Chinese companies on their floating processes in London. It has offices in London and Beijing.