China: Is a provincial approach the next big thing for funds?

A World Bank advisor and a member of the Chinese Academy of Science believe knowing your own back yard generates the best returns.

It doesn't really need to be repeated that China is a vast country. Or so you'd think.

But Pang Chung Ming believes that many foreign fund managers still don't get the message.

"Foreign fund managers are invariably stationed in either Beijing, Shanghai or Hong Kong. They try to do all their due diligence from these three cities. But China is enormous, even more so when you take into account that traveling can still be something of an adventure. Consequently, their cost base is huge," he says.

Instead, Pang, who has had a distinguished career at the International Finance Corporation of the World Bank Group from 1984 to 1992 and now continues to consult for them, believes that focusing on what you know is the best to get around these obstacles. In his case, and that of his partner, Professor Chen Duquan of the Chinese Academy of Science, it is the province of Shandong, just a few hundred kilometers south of Beijing.

Pang and Chen, founders of Qingdao-based Huizhong Investment spend up to six months on a single company doing due diligence. Their team doesn't consist of 'foreign experts' but of home grown talent that they recruit at a young age and spend a long time training.

"We don't hire from other fund companies or securities firms, because we believe many of their employees pick up too many bad habits," says Pang, politely refusing to go into further detail.

Shandong is in many ways an exceptional province. It's best known to foreign investors via the beautiful city of Qingdao, surely one of the most interesting and enjoyable cities in China, and a venue for the sailing event in the upcoming 2008 Olympics.

In terms of GDP rankings, it's one of the richest in China, coming behind only the major cities, and the provinces of Zhejiang, Jiangsu and Guangdong.

But while parts of the coastal province centering on Qingdao and Yantai are very prosperous, parts of western Shandong are wreathed in smog and among the poorest in the country.

Pang believes that Shandong's potential is only now being tapped.

"The present provincial party secretary, Zhang Gaoli, was formerly a vice-governor of Guangdong Province and mayor of Shenzhen. Now that he's here we are seeing a huge pick up in Shandong's fortunes. He's made it quite clear that he's in favour of unleashing the potential of the private sector," says Pang.

Indeed, it's remarkable that Shandong is so high in the GDP rankings given that it's traditionally been kept on a tight government leash. When Zhang Gaoli was first appointed Governor of Shandong in 2002, 70% of the province's GDP stemmed from the public sector, a number which the new governor (now party secretary) was determined to drag down to below 30%.

Currently, many parts of the province still seem stuck in the late 1970s. Just south of the Hebei border, some cities such as Dezhou seem to consist of little more than Karaoke bars and cheap restaurants. Others, such as Cangzhou are wreathed in such foul pollution that at two o'clock you can't see the sun. That's because refining is a big local industry in many parts of Shandong, while the presence of unexpected oil fields is revealed by the bobbing heads of oil extraction machines in other parts of the province.

Pang and Chen, who have cris-crossed the province innumerable times, are convinced that only foot work and hard graft can uncover the hidden jewels in the province.

"We once went to a farm in the back of beyond. We had little expectation of obtaining anything at all, but we had been invited by the local government and we didn't want to cause offence," recalls Pang.

"Imagine our amazement when we stumbled onto a Holstein dairy herd, including six cloned cows. It was mind boggling," he says.

Pang and Chen realized immediately that the privately-owned company was something special. They later learnt that the owner, perhaps wisely considering the early demise of Dolly the Sheep, was moving in a slightly new direction, namely importing high quality fertilized embryos and implanting them into local cows.

China has 8 million diary cows, while demand is expected to eventually require 20 million. Local cows also have very poor milk yields, 2.5 tons per year, compared to developed economy cows with on up to 12 tons or more per year, yet demand for milk is soaring. The traditional morning drink of hot soy milk is still popular in the countryside, but more and more parents are trying to boost their children's physical size through western dairy products. Indeed, the government has even started a school milk scheme. Importing cows is an expensive business, however, which is creating a lot of interest in new insemination techniques.

Pang, who has identified kelp, peanuts and fruit as areas with enormous potential, is convinced that many new, privately-owned companies run into cash flow problems at some point in their lives, and that they often get a frosty hearing from the traditional banking and city establishment.

"One classic case consisted of a female entrepreneur who had taken over a business which had acquired foreign technology.

"She turned it around and was doing a really good job sales-wise but ran into a cash crunch. We'd been doing some due diligence on her company and really liked what we saw. Eventually, she allowed us to put in some cash and take a stake," says Pang.

It's clear that due diligence takes on a new meaning in China, but it's that difference which underpins Pang and Chen's strategy.

It's preferable to rely on genuine audited accounts before you make a purchase but that's rarely the case in China, with companies often running multiple sets of books.

Pang and Chen have realized that it's spending time, rather than money, that is the key to finding out about investments in China.

Time is also the key ingredient to gaining an entrepreneur's trust. Only after really understanding what the entrepreneur wants can an outside investors look to a positive outcome, estimates Pang.

The presence of Professor Chen is vital, since the Chinese Academy of Science still evokes feelings of awe, and helps dilute the impression that the team is interested in the company for purely commercial reasons.

Chen and Pang's outfit is small by international standards. They are affiliated to China's second-largest tobacco group and obtain funds when and as they need them. While the total size of investments is much larger, the typical size of investment for Huizhong's own account is a relatively small Rmb 5-10 million. As such, Pang and Chen are always on the look-out for other direct investors to invest alongside them. In return, they offer detailed due diligence and constant post-investment monitoring of investee companies, including sending in their own people, as and when appropriate. They are able to do this because all the investments are made in the same province. Their preferred exit route is an offshore listing in Singapore or Hong Kong, where much effort has been made to attract more listings by mainland Chinese companies.

"With 1,000 domestic companies already approved for listing in Shanghai and Shenzhen and waiting in the queue, to obtain a listing on either of these exchanges would take at least three years, even if we make the totally unrealistic assumption of one listing per day, including weekends and holidays! As for the listing conditions for the secondary board in Shenzhen, they are almost as strict as that for the main board. Also, it is primarily the preserve of high-tech companies," he points out.

Pang Chung Ming can be reached on [email protected]

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