Banking & Finance

Beating the benchmark

Critics urge caution as more Chinese stocks join global indices


David Webb: identified problems at ArtGo before MSCI did

Stock market investors wanting to benefit from more exposure to Chinese equities might do well to buy some iron disulfide (pyrite) stones for their homes and offices. In feng shui terms, the stones are winners for attracting wealth.

Yet investors may also find the pyrite has a truer benefit as a reminder of the meaning behind its more common name: fool’s gold.

As a series of scandals have shown, China’s financial markets are vulnerable to fraud. That’s become a wider concern because of the speed (too quick for some) at which Chinese stocks are being added to global indices. This week, the MSCI added a third batch of A-shares into its MSCI China and MSCI Emerging Markets Index, raising their respective weightings to 12.1% and 4.1%.

CICC, a Chinese investment bank, calculates that the new weightings will bring up to $40 billion of foreign inflows into the A-share markets. This follows the $80 billion that arrived on the back of MSCI’s first and second steps to include A-shares in May and August.

Much of this money comes from the billions of individual pension and insurance pots entrusted to investment vehicles that track benchmark indices from providers like MSCI. Most of these investors almost certainly assume their savings are safe enough because they’ve been invested in China’s top companies. However, the experience of one firm that was scheduled to be included in the MSCI China Index underlines some of the risks of owning Chinese stocks. Rather embarrassingly for MSCI, the index provider dropped marble manufacturer ArtGo only two weeks after announcing its inclusion in the indices and just five days before its selection was due for implementation. (The Chinese firm, it should be qualified, was listed in Hong Kong and not on the A-share market.)

This followed a Wall Street Journal article, which opened with the sentence: “Coming to your index funds: a $5.9 billion unprofitable Chinese marble miner that has risen 3,800% so far this year.”

As a subsequent article in the newspaper pointed out, a simple “smell test” should have alerted MSCI that all was not right with ArtGo’s rapid share price rise.

Or perhaps it should have listened to corporate governance expert David Webb, who shared his concerns about the company with Hong Kong’s regulator and investment community back in September. Alongside ArtGo, Webb flagged a second company, S. Culture, whose shares had risen eightfold in the space of just three months. Both share prices have now collapsed. Or as CNN put it, “Bitcoin lost 85% of its value over the course of a year. But Hong Kong stocks knock that out in a day.” That was a reference to ArtGo’s 98% plunge in the morning trading session after MSCI reversed course on its inclusion.

The latest incident provides more ammunition for those who argue that it isn’t just the index providers that need to be extra-vigilant. Hong Kong stock exchange bosses need to do the same, if the bourse wants to retain its reputation as a safer alternative to the mainland markets.

Analysis from the Washington Post of what can go wrong in these kind of situations honed in on “nefarious networks” among corrupt individuals, exacerbated by lax corporate governance. It also noted that companies in Hong Kong have the highest concentration of individual directors sitting on multiple boards of any of the world’s leading stock markets.

Webb told the WSJ that he believes ArtGo’s stock was “manipulated”, although an analyst with brokerage BoCom International explained that Hongkongers have seen such rollercoaster moves in the past. “Local investors have seen this movie before. International investors, less so,” he observed.

In ArtGo’s case, it doesn’t seem to be a case of blaming the auditors for rosy reporting: The recent accounts showed two years of losses. However, audit accuracy is a broader challenge for investors. As we highlighted in WiC463 and WiC470, another downside risk is that domestic accounting firms aren’t scrutinising the books effectively enough.

The Chinese have spent a decade trying to create national accountancy champions at the expense of the big four – Deloitte, EY, KPMG and PwC. But the cold reality is a marketplace often wracked by mistrust of audited financial statements (usually followed by the detention of a leading company executive – such as Zhong Yu, chairman of Shanghai-listed Kangde Xi Composite Materials, who was taken into custody in May over an illusory Rmb15 billion cash position; see WiC461).

Some of the blame for rising corporate bond defaults can be laid at a similar door. Tighter funding conditions are exposing how little cash some companies really have as borrowers fail to meet coupon and principal payments, despite reporting supposedly healthy balance sheets.

In recent weeks, that’s been the story in Shandong province where Shandong Ruyi, Shandong Yuhang and Zhongrong Xinda have all seen their international bonds come under intense selling pressure following rating downgrades to C territory (high default risk). They each have domestic auditors (Shandong Hexin, Zhongxinghua and Zhongxingcai) that have been sanctioned or fined for inadequate practices, yet continue to win clients.

Right on cue, MSCI called a pause on further inclusions of Chinese n shares in its benchmarks on Wednesday, although fears about audit accuracy weren’t mentioned as a factor. Instead MSCI said it would wait for regulators to respond to concerns including a dearth of hedging tools and derivatives, a short settlement cycle and holiday misalignment between the mainland and Hong Kong markets.

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