Profitability of Chinese listed companies1 Profitability study: Significance and key conclusions
1.1 Significance of profitability study
Profits are the core of business operations in a modern economy. Drive for profits
keep producers producing and retailers selling. As companies expand, capacity
expansion starts to grow beyond its own means. Fund raising becomes a
necessity. This can be achieved through loans, bonds or stocks. The key for
bank loans or bond issuance is credit worthiness, or borrowers’ ability to pay
back debt. For the stock market, the focus is on present and future profitability, in
terms of earnings, earnings growth, cash flows, margins and market shares. In
the direct capital market, capital investment destinations are determined through
comparing return on equity (ROE). Companies that can deliver earnings and
create maximum return on investment deserve the top picks.
Unlike the original capitalist or entrepreneur, money at the stock market level has
many choices of investment. It is much less attached to the original investment
plan and typically less picky about which industry or management (smart
investors do care about sector and management, but mainly from an investment
perspective, not from a personal one) it will invest in. Money is committed to
make money. The higher and the stronger profits are, the bigger the returns the
investment will reap.
While ROE profitability is at the centre of equity markets worldwide, less
emphasis to it has been given in China. The short life span of China’ s stock
exchange, excessive domestic liquidity in the past years and restrictions on
capital flow all appear to have directed attention away from profitability.
Management of some listed Chinese companies may also not to be focusing on
this issue.
In overseas markets, Chinese companies’ lack of profitability is probably the most
frequently cited concern amongst equity investors. Less anxiety is expressed in 4
the domestic A-shares markets, but a rising awareness of earnings and other
fundamentals has been evident recently. As Chinese equity markets develop and
mature, we believe that domestic investors will place a stronger emphasis on
profitability and demand higher returns on equity.
The profitability issue goes beyond capital markets and investors’ interests. It is
also a central pillar of a country’ s sustainable growth path, because profits
represent wealth accumulation. Improvement in profitability is a proxy of
productivity gains. One key lesson to be learnt from the Asian Financial Crisis in
the late 1990s is that economic growth must be associated with improvement in
productivity and profitability. The old Asian model of pursuing high growth
through continued capital and labour inputs delivered impressive results for years
or even decades, but ultimately failed. There is an abundant amount of
economics literature detailing the “ Asian model” and its flaws, so we shall not
extend the discussion further in this paper.
Nonetheless, it is clear that shifting away from “ quantitative expansion” or a
market share driven development pattern to “ qualitative expansion” or a
productivity driven development pattern is crucial for Chin a’ s long term
development strategy. This is about the sustainability of on-going rapid economic
development. This is about the long-term prospects of China.
Research articles focusing on the profitability and corporate governance of
Chinese listed companies from a macro perspective from China or international
financial institutions have been few and far between until recent years. Moreover,
we took our study a little further by comparing profitability on a global scale as
well as on an industry basis. To our knowledge, this has never been done before,
but is significant in order to understand the strength and weakness of the listed
companies. We also surveyed institutional investors, domestic and aboard, taking
advantage of the unique combination of this project. Again, we believe this to be
a new attempt at such work. 5
1.2 Basic conclusions
The key findings and conclusions from this project are listed below.
1) The Chinese listed companies in our survey generally recorded
respectable profitability, in comparison to listed companies in US, Europe
and Japan. A-shares companies seem to have higher ROE and margins
than those listed in Hong Kong, though a bad macro environment in Hong
Kong in the past few years probably lowered the profitability of Chinese
companies, which receive a large source of their revenue flow from the
SAR. Most overseas investors do not seem to be aware of the fact that the
A-shares have a higher profitability than the Hong Kong listed Chinese
companies.
2) There is a clear trend of declining R OE and net income margins amongst
companies listed in Shanghai and Shenzhen. While average margins in
the mid-1990s are in line with world standards; by the end of the 1990s,
they had fallen significantly. This may be related to the deflationary
environment at the macro level; this downward momentum in profitability is
worrying. Hong Kong listed Chinese companies do not seem to be afflicted
with this problem.
3) The falling margins of the Chinese manufacturing and consumer product
sectors are particularly alarming, because these of the key sectors of
China’ s economy. Profitability of some industries may be tied to the global
cycle, such as petrochemicals and aviation sectors, where price
movements and demand/supply balances are determined by global
markets. Utility companies have the steadiest ROE amongst the surveyed
companies, and enjoy higher margins and returns than their international
peers.
4) Both ROE and net income margins of the China listed companies tend to
fall once the listing process is completed. We divided companies by their
year of listing. From 1994 to 2000, each and every category saw their 6
ROE peak in either the year immediately before listing or in the listing year.
Most classes recorded consecutive falls in profitability since then. There is
no clear evidence that the Hong Kong listed Chinese companies follow the
same pattern.
5) In a poll we conducted amongst overseas and domestic institutional
investors, all the fund mangers surveyed marked profitability high on their
priority list. Most of them also think the margins of Chinese companies are
probably below the world average. While domestic investors are
enthusiastic to invest in the Hong Kong market through the QDII scheme,
only one third of the surveyed international fund managers indicated they
would invest in the A-shares market once QFII is introduced.
Our basic conclusion from this study is: listed companies, investors and stock
exchange authorities all need to place more emphasis on profitability and ROE
because they are the cornerstones of modern capitalism and capital markets. It is
a particularly challenging task, as China is set to liberalise its capital markets in
the next decade. This means both domestic and international capital would have
more options on what, or even whether, to invest in Chinese companies in the
future. Chinese companies will have to compete against their global peers for
capital. Profitability and return on equity are key valuation tools to attract
investors. Improving profitability is also crucial for China’ s long-term prospects,
as the economy needs to raise productivity.