A for effort: Martin Currie's China strategy

Chris Ruffle, head of Martin Currie''s China team, explains where to find hidden gems in China''s domestic stock market.

What's the background to investing in the mainland domestic A share market?

Ruffle: We're an Edinburgh-based fund company which has been investing in China since the early 1990s. In around 1994, I decided the companies offered on the domestic market offered greater private sector opportunities than the ones listed internationally or on the foreign currency B-share market. We finally started investing in A shares in 1997.

How did you get around the regulatory barriers at the time?

We set up a swap agreement with a local broker. We deposited money offshore and the local broker paid us a return equivalent to the return on the stocks we'd picked. They'd use their book position to hedge the market risk.

We attracted some attention on the back of that, and in 2001 we won management of the China Fund Inc, which is a New York-listed closed-end fund of $250 million. We took it over at a 20% discount and I'm pleased to say it's now at a 15% premium.

Once the A share market was opened up, we converted out swap agreement into the open-ended Martin Currie A share fund, now about $75 million in size. That goes through Morgan Stanley and UBS, although we are applying for own Qualified Foreign Institutional Investor quota. You'll remember that in the beginning, the Chinese regulators were interested only in granting quotas to huge international banks and brokers. The hurdle for funds under management then was $10 billion and we were just under that, although we now manage nearly $15 billion.

In fact, we're still the only foreign company with an offshore A share fund, even though the market has been open for nearly two years now.

We also have a Greater China fund of about $125 million and we run China funds in Israel, Sweden and Switzerland. The latest thing, the big growth market, actually, is that we have been winning segregated mandates. That's when pension funds start to give out mandates to invest in China. That's new. Most pension funds have a zero weighting in China, but opportunities are now opening up given that more and more companies having bigger operations in China and corresponding liabilities. We also have a long-short hedge fund, which we set up over one year ago, with about $200 million. In all, that's about $1 billion of funds with a China or Greater China focus.

What's the best performing component of that portfolio?

They all have slightly different criteria. In terms of relative returns, our open-ended A share fund has been especially strong, though, making money year-to-date in a steadily declining market.

What strategy have you been following in the A share market?

The key thing is to understand who owns the company. Then you can understand what they want from it. I believe you have to invest in companies where the management holds equity in the company. You can invest in state-owned companies, and that can be fine for a while, but you have to ask yourself what the state really wants out of managing the company. And the motivation of the guys running SOEs is totally different. Foreign minority financial investors don't rank high in their list of priorities. We look for growth - the company needs to be growing 20% per year. We are also very bottom up. Our analysts always go to the visit the company - that helps us see through much of the boardroom propaganda you get to hear. And once you've read enough Chinese balance sheets, you get to see where the bodies are buried.

Where are they?

Accounts receivable and intra-group transactions. You have to find out the relations between the company and its suppliers and partners - who is the owner? Where did he get his money from? It's also good to speak to rivals. Avoiding disaster in China is half the battle!

Do you use conventional DCF valuations?

I'm not a big fan of that for China. For a start, what is the risk-free rate? The result you get vary extremely. I prefer slightly shorter term, such as the next two to three years growth and what I have to pay for it. I like a company which is paying me a nice cash dividend. And beyond the yield, it means they are not sitting on piles on cash. Usually, private sector companies store huge amounts of cash away, which sits in a bank paying a pathetic rate of interest. Alternatively, it's often squandered on an airline or a chain of hotels! I prefer it if they pay the shareholders and then ask the shareholders for funding for a new project which the shareholder can have a look at.

Do you have any mechanisms for bringing pressure to bear on the companies you invest in? Does your strategy in that respect differ from the strategy you employ in other markets?

With SOEs, our influence is zero. You can create a bit of embarrassment, but really, who gives a damn. But if the management has equity, they are more sensitive to us rubbishing the company by standing up in the AGM and voicing our concerns. What we can do is limited. But in the end I vote with my feet.

Do you use local journalists as sources? They often know a lot, although they don't necessarily publish everything they know?

Yes, in fact, we recently invested in the holding company of Caijing Magazine.

Are you primarily interested in the private sector? Or do you think there are some hidden gems in the public sector? Shandong seems to have some good state-owned companies.

Well, it's very complicated. Things are made difficult by the whole tension between the central government, which wants to avoid the Russian Oligarch situation, the local provincial officials who want to sell everything off, and management (often the same people!) who are very keen to buy. There's numerous exotic ways for the management to gain control, including a trade union fund acting as an option fund and private companies set up in parallel to the listed SOE. As regards Shandong, it has indeed attracted a lot of foreign attention and investment. We are looking at numerous companies, including a supplier of hospital consumables, a maker of petroleum extraction equipment and a maker of synthetic diamonds

How big is the universe of private companies that you target?

In the A shares, we have a universe of just under 100 stocks. In our portfolio, we tend to have not more than 30 stocks. We like consumer-related companies, distribution, retail, media, and famous brand names, such as Harbin Brewery. We also own Yanjing Beer in Beijing, a leading Chinese liqueur company, a wine company and a Tibetan brewery, Lhasa Beer, which is currently doing a deal with Carlsberg.

We also like steady, infrastructure projects, such as Shenzhen Airport, as well as Panzhihua Steel and Wuhan Steel. In the offshore market, we invest in TCL, which is a management-owned mobile phone and home electronics company.

How about strong SOEs like Haier or Qingdao Beer?

Well, Haier is by no means a pure SOE. And we prefer Yanjing Beer to Qingdao. Yanjing is a former Town and Village Enterprise and we prefer its more dynamic management.

Did you invest in Delong?

No, it was obviously dodgy and basically operating a Ponzi scheme. There were lots of rumours about it.

Do you still find private companies starved of funds?

I think it's changed. Access to funds is easier. The problem is that lots of entrepreneurs don't understand the value of their stock. They feel they are raising money for nothing, so they sell stock at six times earnings when they could get bank funding for much less.

Are you worried about the stock overhang in the market?

Yes, along with everybody else, we're worried about the unlisted state-owned shares, the mass sale of which could trigger a big decline in prices. It's not as if the problem is insoluble, it's just that the government has not announced a clear and effective plan. One solution is to take the state shares and inject them directly into the pension fund, which is under funded. That would remove the overhang and help the pension situation. They would then run the fund, subject to rules on selling the stock off. You could also set up a tracker fund or sell them off to foreign fund managers.

Do you feel the new leadership is keen on supporting the private sector?

What I've really noticed is that Hu Jintao and Wen Jiabao are keen on narrowing the gap between the cities and the land, through policies such as guaranteeing land use rights for farmers. Last year, they cut rural taxes. We have been buying into fertilizers and agri-chemicals, companies which are the beneficiaries of these reforms. There was a survey the other day asking farmers what they would buy if they had a bit more money and the overwhelming response was colour TVs - which another reason we own TCL!

Another change we see a lot of changes is in health care, on the back of the privatization in the sector.

Do you prefer to invest in companies which already have a foreign venture capital investment?

We avoid them like the plague! They are exiting when we are buying, so they are dumping their stock. In any case, I think private equity has been a total graveyard for foreign investors.

Nevertheless, we are starting to look at it, but doing by structuring a management buy-out fund. So we'd set up a fund and lend managers money to buy a stake in the company. We would use their stake as collateral, and the fund would also take a stake in the company.