Protect Your China Portfolio From The Midnight Knock

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Includes: AFTY, ASHR, ASHS, CAF, CHAU, CHIE, CHII, CHIM, CHIQ, CHIX, CHN, CHNA-OLD, CN, CNXT, CQQQ, CXSE, ECNS, EWH, EWHS, FCA, FCHI, FHK, FXI, FXP, GCH, GXC, HAO-OLD, JFC, KBA, KFYP, KWEB, MCHI, PEK, PGJ, QQQC, TAO, TDF, XPP, YANG, YAO, YINN, YXI
by: Pauline Loong

Summary

China's corporate world makes few distinctions between the CEOs and the companies they run.

Even the hint of a possible corruption probe into a top executive is often enough to freeze a company’s credit lines and put deals in limbo.

State firms can better survive the commercial fallout that inevitably accompanies such investigations than their private-sector counterparts.

Making headlines across China today (June 12) is the conviction and life imprisonment for corruption of one of its most powerful leaders Zhou Yongkang.

Zhou is little known outside China, but his downfall and the pursuit leading to his arrest have fascinated the nation for months. He was the much-feared security chief and, until his retirement in late 2012, was a member of the Politburo Standing committee, a then nine-man caucus that stands at the apex of Party power. He was convicted of accepting US$21.3 million in bribes, of leaking state secrets and of abuse of power.

For the investor, the anti-corruption campaign has implications that go beyond power plays and the Party's attempts to restore its image and credibility to an increasingly cynical public.

The Chinese corporate world is unusual in that the sins of executives are often visited on the companies they run. When a top executive falls, he typically brings down all around him, sometimes even the company itself.

The institution may be above reproach, but even the whiff of a possibility of an investigation is often enough to stop the normal functioning of business.

Banks are known to pull credit lines, buyers to delay payments, and suppliers to demand cash on delivery. Even closed deals have been known to unwind, as smart players keep their distance to avoid attracting unwanted attention. And the phones, it is said, stop ringing altogether (except for unwanted calls from the media).

Such is market sensitivity to the anti-corruption meat grinder that the slightest hint of trouble can trigger investor panic.

Ask the shareholders of Hong Kong-listed Chinese property developer Kaisa Group Holdings (OTC:KAISY). The company's woes began last October when it had to deny rumors that the chairman was missing and unreachable. At the time, the company's books showed rising sales and a healthy cash cushion.

Then, news broke that some of the company's projects had been blocked by the Shenzhen city government. Speculation was that the management had ties to Zhou, who was already under investigation at the time.

Investors assumed the worst. In the first week of December, the company's share price plunged 20%, the largest weekly decline on record. Kaisa now holds the dubious distinction of being the first Chinese property developer to default on its dollar bonds.

The challenge for investors as China's anti-corruption campaign enters its third year is how to protect the portfolio from collapsing with the midnight knock - how to identify the companies that will survive the inevitable commercial fallout should their management end up in the cross-hairs of the anti-graft watchdog.

In the rare best-case scenario, the impact on the company is confined to staffing problems. The joke goes that a visit by the anti-corruption agency could put a company out of business simply by stripping it of all key staff. The company may be above reproach, but the managers are all in jail.

A state firm, however, never goes down with its management.

Consider the year-long, high-profile corruption probes into current and former executives of state-owned energy giant China National Petroleum Corporation, the parent of Hong Kong and New York-listed PetroChina (NYSE:PTR). Among the fallen were six current and former CNPC chiefs and Zhou himself, who was former chairman of CNPC.

Yet, no one suggests that the state firm might have its credit lines pulled or that other companies might stop doing business with it because of the investigations.

If it is not quite business as usual at the company these days, it is because of the sheer number of executives at lower levels also being rounded up rather than because business partners have been running for cover.

One story goes that the company has a rule requiring its managers to report to their department heads daily. Anyone not reporting is assumed to have been arrested and will be replaced that very day. State firms are better at surviving the fallout than private-sector companies.

For one, they are part of the system. This means that even if the CEO is in trouble, the authorities are likely to weigh in to rescue the company - possibly working with the banks to restructure its loans or even provide fresh credit.

Private-sector companies, however, are on their own. And the line between personal assets and company assets is often blurred. The company is the management and the management is the company. If the chief executive's assets are confiscated, the company's coffers are likely to be empty.

Furthermore, the chief executive in the private sector is typically the company's sole decision maker. If the CEO is unavailable because he or she is helping investigators with their inquiries, business grinds to a halt.

Even regular bill payments cannot be processed as the one and only person authorized to sign off on the paperwork is not around. This does not happen in a state firm where a successor is always in place.

State firms in China have their fair share of problems. But, as far as surviving the anti-corruption meat grinder goes, they are a better bet than their private-sector counterparts.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This report has been prepared on the basis of information that is believed to be correct and from official and other sources believed to be reliable, and makes no express or implied warranty as to the accuracy or completeness of any such information.