Jia Tan (TJ)
Head of Research, China Equity Long/Short, UBS O’Connor

The challenging environment for China’s equity market continues, but we find the renewed focus on state-owned enterprises (SOEs) and the latest policy reform compelling. As high quality assets that can generate sustainable and high dividend yields become more attractive, we believe SOEs could be a major investment theme this year alongside generative artificial intelligence (AI).

SOEs are an important part of China’s economy, with their total revenue accounting for almost 70% of China’s GDP, and make up the bulk of what are considered foundational and security-related sectors such as energy, infrastructure, public utilities and finance. Given their importance, the government has carried out overhauls over the years to upgrade and align these companies better with changes in national goals

Redefining profits

The latest round of policy reform is to make SOEs more competitive and strengthen their returns. The work is centered on improving aspects of technology, efficiency, talent and branding. Chinese regulators have urged investors to look at a wider set of metrics beyond total assets or revenues, to bring in total profits, debt-to-asset ratio, return on equity, per capita labor productivity, the ratio of research and development spending to revenues, and the ratio of net cash flow to revenues. The broader scope is oriented around how to assess profits, so that SOEs have higher incentives to align their interests with minority shareholders.

At the same time, Chinese regulators are expanding the definition of profits. The so-called “valuation system with Chinese characteristics,” first brought up last November, would go further than standard valuation metrics and take these companies’ social contribution and impact on the overall economy into account. The government’s call to reevaluate and rerate SOEs with the new system has been interpreted as a call to buy SOEs, but even if you put that aside, the higher dividends alone warrant another look by investors.

There are challenges with any government reform, however.

Inefficiencies found in SOEs can often be traced back to the principal-agent problem since they are owned by the state. SOEs (agent) and the state (principal) could have a conflict of interest or priority. For example, it is hard to create strong performance incentives for SOE management when their stake in the companies is low and compensation is not quite at a competitive level. From an academic perspective, to improve the efficiency of SOEs systematically would require first solving the principal-agent problem. Without it, this round of reforms are not likely to yield satisfactory or sustainable results.

That said, we believe that we understand the government’s ambitions. As we work to identify investment opportunities presented in the current drive for reform, we ask ourselves these three questions.

1. Is this time really different?

SOEs were largely abandoned by investors before. We have experienced cycles of SOE reforms in the past, and we see hurdles for the current round. Nonetheless, given the low base and strong guidance by the government, we think financial improvement in SOEs is achievable over a one- to two-year time horizon. In our view, this presents an investment opportunity.

2. Why participate in this theme?

SOE reform is one of the two major investment themes we have identified this year. While the correction in recent months has created attractive opportunities in other industries, we are watchful of the effect of reflexibility – investors trading on how they perceive market movements instead of the fundamentals of economic activity, thereby creating a self-fulfilling cycle.

We assess a thematic investment from both a fundamental and market perspective. In this case, weaker than expected economic growth, strong policy support to rerate SOEs, continued low valuations for SOEs and low risk appetite by the market all help to explain most of the SOE outperformance so far this year.

While there were cuts to deposit rates by major banks and to lending rates by the People’s Bank of China (PBOC) in June, we are not anticipating a return to large-scale “big bang” stimulus of prior years. Instead, we think targeted support for consumption, housing and infrastructure is more likely.

In our view, not a lot has been done to ease the burden of weaker profitability for many industries and businesses. Less favorable supply and demand dynamics and stronger pricing competition pressurize the most energetic part of the Chinese economy, i.e. privately-owned enterprises – as does weakened confidence in disposable income growth. Entrepreneurs are in a wait-and-see mode, not investing proactively to capture future opportunities, because it takes time to restore confidence after what they had experienced in the past three years.

For that reason, we think that the SOE story has come in at the right time and the right place. Should the current macroeconomic environment remain largely unchanged, SOEs could continue to outperform the broader market longer under the new valuation system.

3. What justifies the investments?

In the past, investors would prioritize the P/B-ROE (price-to-book/return on equity) valuation model for asset-heavy businesses and P/E (price-to-earnings) multiple for growth stocks. The EV/EBITDA (enterprise value/earnings before interest, taxes, depreciation and amortization) or DCF (discounted cash flow) model was also sometimes used as the reference point. However, the low interest rate environment makes it hard for asset allocators in China to manage their assets and liabilities, especially in finding more stable and high interest generating assets.

SOEs in areas such as telecommunications operators or oil companies have recently (within the last 12 months) shown that asset allocators can tolerate slow earnings growth as long as it is stable. Consider the 2.7-2.8% yield from 10-year Chinese Treasury bonds and the 3-3.5% rate from savings products most recently sold by life insurance companies; the dividend yield of these SOEs could head to a 3-6% range depending on how resilient their business models are.

For example, a utilities company in a dominant market position could potentially rerate if it delivers a 3% dividend yield, but a bank may need a 5% dividend yield to be in a similar position. Bank earnings have more peaks and valleys and a higher dividend may be required by the markets to compensate for potential disruption due to the credit cycle. This premise will be the anchor we use to evaluate SOE stocks under this thesis.

And changes have already been set in motion. Based on our primary research, there are indications that major central SOEs are preparing plans to improve capital return. Such plans will likely include an increase to the dividend payout ratio and implementation of a share buyback plan. To be more profits-driven than scale-driven is the end goal of the reform plan, but more proactive communication with stakeholders and investors would be a welcome and encouraging start.

The SOE premium now

At this juncture, we look to embrace more Chinese SOEs based on recent market developments and the opportunities available. While we are in no way momentum chasers, we think SOEs have the potential to continue to outperform the broader market in uncertain market conditions.

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