Active engagement key to unlocking alpha in China

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By David Smith, Senior Investment Director – Asian Equities, Aberdeen Standard Investments

There’s a common misperception that Chinese companies retain a rudimentary understanding of environment, social and governance (ESG) issues. That may have been true a decade ago.

But today there’s growing appreciation among Chinese firms of the value that engagement on ESG factors can bring. This evolution in understanding is happening at a company management level, and this is creating opportunities for investors to generate alpha.

Driving returns
Being an active shareholder is key to driving investment returns in China, in our experience. Passive investors aren’t able to make the same positive impact on the companies they own.

Being active means engaging with companies after buying them, constructively asking questions of managements with a view to encouraging improvement. This process allows investors to learn how a business operates and assesses risk.

Regular interactions also enable 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.

In practice, there are two types of engagement: proactive suggestions around 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.

Investors should focus on the former and look to build rapport and trust with management, because being close to the decision-makers will facilitate more effective engagement.

ESG engagement
Investing in firms with strong ESG standards improves the chances of avoiding loss-making corporate failures and scandals. For example, implementing sustainable practices can improve a company’s brand perception and customer loyalty. It can also guard against catastrophes.

One area where Chinese companies consistently need improvement is disclosure around ESG topics. Weak disclosure of information leads to market inefficiency. This creates alpha opportunities for investors who do their homework and engage with companies on ESG.

This year China’s securities regulator is drawing up new guidelines to improve the quality of disclosures among listed companies and to protect investor interests.

Many Chinese firms now outline their thinking on sustainability, their aspirations to reduce their carbon footprint and the frameworks they have in place to negate ESG-related risks.

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 well-being 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. There’s a race for talent, particularly IT expertise, as companies move into advanced technological industries and digitalisation. Investors need to engage firms on how they are working to attract and retain talent.

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

Improving disclosures
Lack of disclosure led one of China’s top retail and private banks to receive a poor ESG rating from MSCI. However, our engagements revealed that it had sound processes in place.

We learned that the bank took ESG factors into consideration in lending decisions, with policies to regulate loans to sectors facing structural headwinds such as coal. Its aim was for borrowers to improve their green footprint to stay relevant amid the shift to a low-carbon economy.

The bank also has a sound digital strategy, investing into artificial intelligence, face recognition and block chain technology to improve risk management. Plus it runs an in-house university for staff education and training as well as development programmes to foster talent.

However, it needed to do more to disclose these initiatives, which might allow investors to appreciate the company’s competitive advantages more fully.

Separately, MSCI gave a low ESG rating to a Chinese solar panel producer on the grounds that it lacked a water conservation strategy or targets. The company has never disclosed data on water consumption, intensity or reduction.

But again, our engagements revealed that the company 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 the company was able to provide more granularity on its operations, it would be well placed to receive an MSCI upgrade. An improved ESG rating is an indication of company quality, potentially making it more attractive to investors and leading to an increase in share price.

Ultimately ESG engagement is about buying into change. Companies 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.

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Media Contact

Noorul Hijaz

Seven Media

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