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When you think of investing in China what comes to mind? A big internet name or a tech hardware maker? The well-known companies that attract investors have tended to be fast-growing enterprises that retain earnings for reinvestment rather than paying them out to shareholders. Emerging economies often pay little in the way of dividends before they mature. But more and more Chinese companies realise that distributing income attracts a more stable investor base than more fickle domestic investors. That realisation has been nudged along by new rules requiring firms to have clear dividend policies. As a result, dividend investing in China is growing up.
Pushed by low rates, pulled by demographics
Income – or the lack of it - has been a dominant theme for investors since the extraordinary monetary response to the global financial crisis. Historically low interest rates have forced many to seek yield in different places, from high yield bonds to emerging markets.
At the same time, countries with worsening demographic arcs have woken up to the demands of an ageing population that needs to be supported in retirement. One of the Chinese’s government’s solutions is to encourage companies to increase dividends which will provide income for investors.
Higher dividends as a matter of policy
In line with this government effort to shape corporate policy, the China Securities Regulatory Commission (CSRC) published a new Code of Corporate Governance for Listed Companies in 2018, which included a number of shareholder-friendly updates. Fidelity supported the initiative by engaging with the CSRC at the draft stage of the Code and urged regulators to insist companies set clear dividend policies.
Indeed, the final version of the Code stipulated that management should lay out its dividend policy in the Articles of Association and justify why cash dividends were not being paid despite sufficient capital on the balance sheet. This was a significant step forward for income investors because it demonstrated that regulators were aware that companies could operate more efficiently and put the onus on companies to try. Over time, we expect this directive permanently to shift corporate attitudes in China and to lead to a culture of higher dividends.
SOEs could distribute more to shareholders
State-owned enterprises (SOEs) have an implicit national interest element in their mandates. This manifests in different ways. Telecoms companies support a national priority by building out 5G infrastructure. Meanwhile, banks support economic growth through loan provisions. What’s changing now is that other SOEs could be directed to prioritise shareholder returns. These companies’ balance sheets are generally in good shape, giving them the means to pay out bigger dividends. As central and local governments grapple with the challenges posed by an ageing population at the same time as slowing economic growth, they are putting pressure on SOEs to start distributing excess capital.
Source: CLSA Dividend Wave, 2018
Source: CLSA Dividend Wave, 2018
When demographic deficits come along, fiscal deficits are usually not far behind. The health and social care costs of supporting an elderly population are placing a strain on public finances and prompted the government to set up national and provincial social security funds to help shoulder the burden. An important source of funding for these entities will come from investment holdings in SOEs.
China’s GDP growth will continue to slow as the economy matures. The government alluded to this when it cut the long-term growth target in March 2019. As growth slows and reinvestment opportunities become scarcer, there is a compelling argument for companies such as SOEs to increase distributions.
Payout ratios have jumped since 2014
Given the dominant contribution by SOEs to dividends, it is important to understand them to when considering equity income investing in China. State-owned enterprises are dominated by the financials, energy and real estate sectors whose profits tend to be cyclical. But cyclicality doesn’t suit income investors, who prefer steady earnings and dividends.
The government is bridging this divide by implementing structural changes to encourage more shareholder-friendly policies with the potential, taken together, to deliver more stable returns for shareholders. These include improving corporate governance, increasing management accountability and instigating supply-side reforms. A number of industries are also undergoing consolidation and rationalisation.
In fact, these initiatives are already having an effect. On a like-for-like basis, aggregate payout ratios in most sectors appear to have risen in recent years. Internet companies are a notable exception. They tend to still be in growth mode, preferring to retain capital to invest. Excluding them from the MSCI China H-share index shows that payout ratios among the rest climbed from 30 per cent to 36 per cent of earnings between 2014 and 2017. Major SOEs have led the way by substantially boosting distributions. For example, Sinopec increased its payout ratio from 25 per cent to 81 per cent between 2009 and 2018, and SAIC Motor from 5 per cent to 41 per cent over the same period.
Source: CLSA Dividend Wave, 2018
Source: Refinitiv, August 2019
Creating a dialogue with companies: A case study
As asset managers, we have a responsibility to work with companies, both private and state-owned, to develop awareness about how corporate policies can affect shareholder value. An important component of that is a well-designed dividend policy that attracts committed investment capital.
Our team recently engaged with a leading Chinese SOE. This is an industry-leading business, with superior cash flow generation and strong management. It has a good corporate governance record and a leadership committed to treating all shareholders fairly. However, its recent dividend payouts have been erratic.
A fluctuating payout ratio in a climate of weakening macro-economic conditions can be interpreted by shareholders as an indication of liquidity stress. Investors, particularly those motivated by income, are wary of by unreliable dividend payers that cannot be relied upon through market gyrations. Even if a company is offering a high yield, investors have to be confident that the dividend will be maintained during a downturn in order to continue owning the stock.
Despite being a strong and resilient company, the SOE’s unstable dividend policy was sending the wrong message to the market, and the share price indicated the company was being valued as a highly cyclical business rather than being recognised for the value of its yield.
In many cases, company managements realise the benefits of paying out sustainable dividends but become frustrated when this approach fails to attract a stable investor base. Part of the problem is around communication and building trust with investors. To counter this, we advised the SOE what we thought a minimum dividend payment could be over the next three years, and suggested the company make a public commitment to that level and exceed it if the business outperformed.
We expect such a statement will support the company’s investment proposition and could turn it into one of the highest yielding stocks in the region. Investors may be reassured by the progressive and transparent dividend policy, and perceptions of the stock could be transformed from being at the whim of the cycle to a dependable income story, opening up the company to larger pools of global capital.
The early signs of the engagement are positive. The SOE has responded favourably to our message and taken the decision to investigate the issue more thoroughly by allocating resources to a working group to study its dividend policy, how it could be improved and our proposals.
Income portfolios can benefit from a China allocation
So how should an international investor react to this changing landscape? There are currently very few equity funds solely targeting China for income. China’s ‘new economy’ is seen as a growth story, so dividend policies are out of fashion. But, needs must and if the low-yield world persists, that could change. Investors will look to other regions for income, and China, as a large market with good liquidity, a relatively stable currency compared to other emerging markets and an increasing focus on shareholder distributions, could form a long-term pillar of income strategies. If China emerges as an income story, investor capital could become stickier and companies will in turn be rewarded for improving their dividend policies even further.
Further opening up of the market to overseas investors could facilitate this process. China’s markets continue to be dominated by domestic investors who can be flighty during periods of market stress. Foreign investors, particularly those with an income bent, tend to take a longer-term view and look through temporary market gyrations.
We are convinced the government is committed to developing transparency and accountability among Chinese companies and recognises the benefits of a progressive dividend policy, and that makes it hard to ignore China as an income destination. We think any sort of income strategy focused on emerging markets or Asia could benefit from exposure to China and, as the market matures further, their allocation will only increase.