The rules of alpha engagement in China

Building rapport with company management is key to unlocking sustainable alpha

If you’re a passive investor, you’re missing out on the chance to make a positive impact on the companies you own. So what does it mean to be an active shareholder?

Being active means engaging with companies after you’ve bought them, constructively asking questions of management with a view to encouraging improvement. This can help to drive investment returns, in our experience.

Engagement means different things to different people. In practice, there are two types: proactive suggestions around environment, social and governance (ESG) issues; and remedial efforts to get a company back on track in response to a negative event.

In proactive engagement, investors typically focus on ensuring the foundations for growth are in place, particularly around a company’s internal risk controls and the strength of its capital position. Remedial engagement efforts only happen once something has gone wrong.

Although the latter often garners more public recognition, we think investors should focus on the former. Better to be a considered driver than an accident-prone one.

Engagement is an illuminating process, enabling investors to learn how a business operates and assesses risk.

Engagement is an illuminating process, enabling investors to learn how a business operates and assesses risk. The best approach is to build rapport and trust with management; being close to the decision-makers means investors can engage with them more effectively.

Regular interactions also allow investors to assess the competence, character and commitment of company boards and management teams. As such, they can either alleviate concerns or raise awareness of additional risks.

A-share companies are only now beginning to understand the value that can be created by engagement on ESG factors. We are seeing change at a management level, which is creating opportunities for alpha.

For instance, implementing sustainable practices can improve a company’s brand perception and customer loyalty. It can also guard against catastrophes. Thankfully, creating a clean, green environment is a priority in China, so awareness of climate change is relatively high.

In contrast, state guidance on social factors such as how companies interact with employees, vendors and society more broadly is less well developed. Hence it requires more engagement. Supporting employee wellbeing and adhering to fair labour principles can lead to a more engaged, stable and productive workforce, which will create value in the long run.

Being viewed as an attractive employer has become key in China’s increasingly knowledge-led economy. There’s a race for talent, particularly IT expertise, as companies move into advanced technological industries and digitalisation. We engage regularly on how firms are working to attract and retain talent.

Other social issues include supply chain management and establishing a code of conduct for suppliers. We also examine health and safety policies to understand what protections companies have in place to prevent loss of productivity.

Finding an edge

Today A-share companies engage with shareholders, which was not the case 10 years ago. Investor engagement used to be solely about dividend policies. Analysts only needed to get their assumptions right on revenues, profits and valuation to determine whether to invest.

Now that’s not enough. In a market where information is increasingly available, investors need to find an edge. ESG engagement is how to find sustainable alpha, in our view.

One area where Chinese companies consistently need improvement is disclosure around ESG topics. Weak disclosure of information leads to market inefficiency, which presents investors with opportunities to generate alpha.

Companies selected for illustrative purposes only to demonstrate the investment management style described herein and not as an investment recommendation or indication of future performance.

China Merchants Bank* (CMB), for example, is widely recognised as China’s top retail and private bank. However, it received a poor ESG rating from MSCI. We put this down to the company’s lack of disclosures, more so than not having adequate processes in place.

The bank takes ESG factors into consideration in its lending decisions. It has policies in place to regulate loans to sectors facing structural headwinds, such as coal. Its aim is for borrowers to improve their green footprint in order to remain relevant amid the shift to a low-carbon economy. However, it needs to do more to disclose these initiatives.

Similarly, CMB has ploughed investment into financial technology over the years, giving it an edge over peers amid the growing threat of disintermediation that hangs over the sector. CMB has a sound digital strategy, investing into artificial intelligence, face recognition and block chain technology to improve risk management. It just needs to outline this more clearly.

It also runs an in-house university for staff education and training as well as development programmes to foster talent. But it could also do a better job of promoting these efforts, allowing investors to appreciate the company’s competitive advantages more fully.

Moreover, Centre Testing International Group – which tests product quality in China and issues inspection certificates across industries – has received MSCI’s lowest ESG rating.

MSCI couldn’t determine the company’s policies on talent retention, data protection and emissions monitoring. Yet our engagements show Centre Testing has systems in place.

It runs a talent training centre, a mentorship scheme and graduate programme and systematically reviews staff turnover rates. It also holds certificates proving it meets the most widely used information security management standards in the world. It just needs to disclose these things, which is what we are engaging with the company on.

MSCI also gave a low ESG rating to LONGi Green Energy Technology Co., a solar panel producer, saying it lacks a water conservation strategy or targets. The company has never disclosed data on water consumption, intensity or reduction.

But again our engagements revealed that LONGi runs a recycling system to conserve water, monitors water supply and reviews water consumption data regularly. It also meets global environmental standards and regularly upgrades technology to minimise energy consumption.

If LONGi can provide more granularity on its operations, it will be well placed to receive an MSCI upgrade. An improved ESG rating from MSCI is an indication of company quality, potentially making it more attractive to global investors.

In addition, SAIC Motor – a manufacturer of autos, parts and accessories – has admitted its annual report is not detailed enough after it received a negative assessment by the global Climate Action 100+ Net-Zero Company Benchmark.

The CA100+ relies on public and self-disclosed data to assess companies on emissions standards. SAIC’s statements about the need to reduce the carbon footprint within its value chain are broad, chiefly driven by the need to be more competitive in fuel efficiencies.

Yet the need to gain government approvals before production can even start on next-generation vehicles necessitates that SAIC meets high standards, or else it would incur costs and likely miss out on future customer demand.

Our engagements revealed the autos manufacturer is instituting a new reporting framework across its supply chain. It will combine these insights with those from its original equipment manufacturers to inform its data reporting in future. Disclosing these efforts could alter investor perceptions, to the company’s benefit.

Buying into change

For engagements to be impactful, investors should draw up a bespoke agenda for each company and be thorough in their preparations. They also need to be patient. We have seen a growing appreciation among our investee companies that we are in China for the long term. That helps to improve the dialogues we are having.

Our access to companies has improved to the point that some firms are actually approaching us for ESG engagement advice. Still, there remains plenty of room for market advancement.

For investors, it is about buying into change. Company managers are increasingly open to disclosing more information, adapting their business models and adopting a more market-oriented mind-set. There’s an element of that happening in China today that’s very exciting.

* We hold the companies listed in bold. These are provided for illustrative purposes only.

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