China reforms its unloved state-owned enterprises to win back investors

China’s unfashionable state-owned enterprises are getting a second look from investors as their stocks beat the broader market and Beijing judges executives on share price performance.

A sub-index of SOEs with minority listings in Hong Kong has outperformed the city’s benchmark index by 40 per cent since the start of 2021, although it is flat in absolute terms amid an extended stock market rout.

Many unloved SOE stocks have single-digit price-to-earnings ratios, while offering healthy dividend yields that averaged 7 per cent for the Hang Seng China Central SOEs index in 2023, compared with 4 per cent for the broader Hang Seng China Enterprises index.

Rekindled investor interest in China’s state-owned behemoths would also reflect their continued economic prominence and an ongoing campaign by Beijing to improve financial performance. As their biggest shareholder, the central government stands to benefit from higher valuations and larger dividends.

“SOEs used to have lower revenue growth, lower returns on equity and much higher balance sheet leverage than private companies. But after 2020, we’ve seen SOEs improving,” said Winnie Wu, a strategist at BofA Securities in Hong Kong.

There are parallels with government campaigns in Japan and South Korea to improve stock market valuations, she said, noting that buying into SOEs might suit fund managers with benchmarks that require exposure to China. “I think investors have become more receptive [to buying SOE stock] but it’s certainly not a consensus, well-owned theme yet,” she said.

The giants of China’s command economy have rarely drawn investor attention, although the likes of Sinopec, PetroChina, ICBC and China Mobile are among the world’s biggest companies by revenue. Many floated minority stakes during the 2000s.

Over the past three years, Beijing has brought in financial targets for SOEs including for return on equity or net profit growth. But this year, the government took an important additional step, telling SOE management it would start assessing them based on stock market performance.

“Compared to the previous rounds of reform, this reform is going to have greater impact because it directly ties financial market indicators with [performance evaluation] for senior managers in SOEs,” said Robin Huang, a law professor at the Chinese University of Hong Kong.

In the short term, analysts see the changes as part of a strategy to stabilise the country’s foundering stock markets, among the world’s worst performers.

There are also longer-range objectives for SOE reform, including securing alternative sources of public revenue as land sales decline, while keeping debt levels under control.

Although historically less profitable, SOEs have matched returns on equity at private companies over the past couple of years and paid out more of their earnings as dividends, according to BofA Securities.

Sceptical analysts point out that the convergence of returns is more about privately owned companies struggling than SOEs improving. “Let’s say you have a bull market. Will you buy an SOE? No. You’ll buy the company with real performance,” said one analyst who asked to remain anonymous.

SOEs are still an important tool of state policy, and some investors fear the trade could quickly go sour if government priorities change.

“SOEs have multiple goals. Not only the profitmaking goal as a market entity, but also many other policy goals,” Huang said. “Which one will stand out as more important at any particular stage or period? It’s a policy issue for the government.”

Forced to choose between the new financial metrics and earlier mandates, some expect the SOEs to emphasise social stability. “Reducing unemployment is more important than [improving] return on equity”, said the analyst who preferred not to be named.

According to an employee at one SOE in the energy sector, there have been noticeable changes in the past few years, with an emphasis on efficiency. But “formalism still exists”, the employee said, with some processes still taking place outside the new streamlined procedures.

Reasserting state control over the economy has been an important theme of President Xi Jinping’s leadership. That guarantees the SOEs’ position, but it may not be fully compatible with efficient management and returns for outside investors.

“SOEs are an important material and political foundation for socialism with Chinese characteristics,” Xi said during a speech in April 2020. “They must be made stronger, better and larger.”

But if the push towards market reform is real, the government’s ability to use SOEs to help stabilise society might be weakened, said analysts.

“Once forces of financialisation are unleashed, it will be very hard to rein them back in,” said Michael Useem, a professor of management at the Wharton School.