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In an average year, a state-owned giant like China Railway Group would be considered a boring defensive stock with stable fundamentals and middling return prospects. But 2023 has been extraordinary for the rail builder so far, with its shares surging more than 50 per cent from the start of the year to May 9th.
Other state-owned enterprises (SOEs), such as China Petroleum & Chemical Corp., known as Sinopec, and Aluminium Corporation of China Ltd., or Chalco, have also soared in the onshore market, where the CSI Central SOE Composite Index has risen 13 per cent this year, compared with a 0.4 per cent gain in CSI Privately-owned Enterprise (POE) Composite Index. In recent months, as the government pushes forward a new round of SOE reforms, investors are betting that the firms will heed officials’ call to boost shareholder returns.
Try, try again
It’s not the first time China has tried to reform SOEs, which are known for unsatisfactory corporate governance and a lack of adequate incentives to align management interests with those of shareholders. In this year’s campaign, announced in January by China’s state asset regulator, the government started using return-on-equity (ROE), to evaluate performance of central SOEs’ management. Regional authorities, which oversee local SOEs, are expected to adopt similar guidelines.
In order to get a higher ROE, a firm with excess cash may pay out more dividends. And indeed, it’s happening. Some state-owned firms in the telecom, oil and metal sectors recently announced plans to lift their dividend payout ratio for 2022.
The new reform push comes at a critical time for China’s economy, as the government grapples with the residual effects of pandemic-related restrictions that suppressed activity. At the same time, the multiyear property market downturn led to a slump in land sales, a major source of local governments’ income, adding to constraints on their capacity to roll out more stimulus. Over the long run, China will face more fiscal pressure to fund its social welfare programs as the population is rapidly aging and the birth rate is falling.
If SOEs, which by some estimates account for around a third of China’s gross domestic product, can strengthen returns to government shareholders, it would significantly alleviate fiscal pressure and bolster economic growth.
A long road to reform
China’s efforts to overhaul its sprawling SOE sector dates back to the late 1970’s when Deng Xiaoping kickstarted economic reform and opening. Over the past decade, policymakers have stepped up efforts to upgrade SOEs as China shifted its focus to higher-quality economic growth. They cleaned up excess capacity at state-backed enterprises, weeded out ’zombie’ companies with weak fundamentals and merged firms to create national champions that can compete on the global stage.
Still, there is room for improvement, especially in capital efficiency. The weighted average ROE for A-share listed nonfinancial SOEs was 8.8 per cent in 2022, down from 9.9 per cent in 2012. 
Of course, ROE as a financial metric is not without its flaws. For example, ROE can be skewed higher at companies with unhealthily high debt loads. But when compared with net profit, which policymakers previously prioritised as a key metric for SOEs, ROE tends to provide a better picture for investors of a firm’s overall ability to generate sustainable returns.
If China’s reforms deliver, we can expect to see investors taking another look at SOEs. Most would be happy to pay premiums for companies with consistently high returns-on-equity. Kweichow Moutai Co., a maker of the fiery liquor baijiu, has delivered ROEs above 20 per cent for nearly two decades. Partly as a result, the company traded at almost 10 times its book value.
Although SOEs in certain sectors such as property, with government support and access to funding, have outperformed their POE peers in the capital market, most state firms still look less attractive to investors. As of May 9th, SOEs traded at 1.2 times book value, while POEs traded at 2.9 times on Shanghai and Shenzhen exchanges. China’s securities regulator has recently expressed concerns about the low valuations and vowed to build a “valuation system with Chinese characteristics.”
In addition to increasing attention to shareholder returns, SOEs may enhance engagement with investors and improve transparency, which is important in boosting their attractiveness to global investors.
Despite the recent market rally, investors are still sceptical about how the reform will play out over the long term. One of the key challenges for SOEs is to balance national service with business priorities. Even so, we believe the SOEs in less strategically important and fully competitive industries should be required to produce a minimum industry average return on assets.
Furthermore, more progress needs to be seen in building an effective incentive compensation scheme, one that aligns senior executives’ priorities more closely with returns for shareholders.
It is a long journey for China’s state sector to become more market oriented and shareholder friendly. But we think the new focus on return-on-equity is a step in the right direction.
 according to data from Wind Information Co.
 according to the local indices compiled by China Securities Index Co.