China’s Enterprises’ Development and Governance

(In an interview with CCTV China 24 on August 10th, 2012, Pro. Zhu Ning, Deputy Director of SAIF, shared his opinion on China's enterprises' development strategy and governance)

Enterprises must chart focused corporate strategy to encourage investment and benefit economy. With 79 companies in the Fortune 500 list for 2012 published last month, China was the second most represented country in the rankings.

While many Chinese business leaders and managers feel excited about further growth of the corporate businesses and their increasing influence among international counterparts, some are concerned.

First, most of the leading companies from the Chinese mainland come from monopolistic or semi-monopolistic industries, where entry barriers are high and competition is limited. Second, among such large companies, their rankings will drop if ranked by their profits instead of the revenues, the common standard used by Fortune magazine.

Also, private companies feel that the further increase in the size of State-owned enterprises will hinder the growth of private ones and eventually crowd out their own businesses.

Such fears seem to coincide with some of the comments made by the World Bank earlier this year on the sustainability of Chinese economic growth over the next two decades. Based on their research, the World Bank and the State Council Development Research Center of China together recommend that, to make Chinese SOEs more competitive, an SOE's size should be limited, its growth model modified, and its dividend payout increased.

Such diagnoses and recommendations seem to be in line with the feelings of common people. More and more college graduates target SOEs as their ideal employer. "Even though the nominal salary is not as high, SOEs provide unparalleled benefits, and the work is not that demanding," as one put it.

At the same time, more private company owners are voicing their concern that SOEs are growing so big that they remove growth potential for private enterprises, many of which start at a disadvantage in resources, financing, and government support.

Senior officials from the State-owned Assets Supervision and Administration Committee admit that, with their increase in size, SOEs' operational efficiency and profitability have not improved accordingly.

So what has gone wrong? One answer may lie in corporate strategy. With the committee's objective of reducing the number of SOEs, the remaining ones have not only become bigger, but also more complex. By acquiring other smaller ones, remaining SOEs ventured into more sectors and businesses that they were not originally familiar with.

Investors in general are not keen on such diversification. Reviewing the corporate strategy of Western firms in the past three decades, scholars find a clear trend that companies from the US, Europe and Japan show a pattern of becoming more focused in their line of business. The number of conglomerates, defined as companies with at least five major lines of business, has decreased steadily over those 30 years. In contrast, the number of specialized companies, whose revenues come from no more than three lines of business, has increased.

Corporate managers have quoted operational and stock market performances as major reasons for the trend. Investors tend to favor companies with clear business models and competence to excel in them. For example, Warren Buffet is famous for sticking with his investment philosophy of picking simple businesses with clear competitive advantages in the long run.

A most recent case reflecting such a trend is the announcement of a split-up by News Corporation. As one of the largest media companies in the world, News Corp has been facing challenges in how to manage its stagnant traditional publishing business, in contrast with the fast growth of the video and Internet businesses. Although the publishing side still commands the majority of the corporation's assets, its contribution to profits has been decreasing steadily to about one-third of its profits.

The publishing business is also facing investigations over illegal eavesdropping, which not only blemished the company's public image, but also shook investors' confidence in the business and caused its stock price to under-perform.

To revive growth and restore investors' confidence, the Murdochs and News Corp decided to split the company into two, one focusing on publishing and one on video and movies. News Corp's share price shot up by about 30 percent within a week of the announcement.

So could such a decision work in China? The answer is yes, according to my own research. I conducted a study that divides all companies included in the Shanghai and Shenzhen 300 Composite index into groups based on whether the companies are diversified, or focused, in terms of lines of business. I then compared the operational performance and stock performance for those that have more diverse business lines, with those that have more focused business revenues. I found that, consistent with investors' preference in the West, more focused investors perform better, both in operational efficiency and stock prices, than the more diversified ones.

So why do investors prefer more focused companies?

First and foremost, many investors believe that capital markets are more efficient than average companies at allocating capital. As a result, investors prefer to see listed companies distribute cash flow back to their investors, and let them decide whether they want to go along with companies' investment plans. Given that corporate managers are influenced by agency problems and shortcomings in their own behavioral patterns, investors sometimes prefer to avoid complex businesses where internal markets play too great a role

Corporate governance can be another issue. According to research, corporate managers have the tendency to retain and squander company cash flow for their own benefit. For example, researchers found that companies with more corporate jets and sports stadiums named after them have poor corporate governance and stock performance. As the size of the company grows, there are greater resources and cash flow at the management's disposal, which concerns investors more.

Finally, if investors prefer to diversify across different sectors of the same company, specialized and divided companies would give investors more flexibility in choosing the best player within the respective industry than the choice by conglomerates.

Granted China is still going through the stage of fast economic growth, and the size of Chinese companies is bound to increase with the economy. However, it is important to point out that increasing the size of corporation does not necessarily require the parent companies to put all their subsidiaries within the same group. Flexible corporate structure, such as a parent holding company, may be more effective in increasing its asset size and market capitalization, if this is what the parent company pursues.

Several modern corporate finance tactics, such as spin-off, split-off, and carve-out, are available to Chinese companies when they consider restructuring and improving their investor relationship. Successful examples, such as the split-ups of News Corp and Marathon Oil, prove that such restructuring tools can effectively improve corporate performance, at least in the short- to medium-term.

Some SOE senior managers are concerned that splitting up a parent company may result in a decrease in its asset size or loss of corporate control. The lessons from the more developed capital markets suggest that, as long as the valuation and transaction are carried out at fair market value, the restructuring of SOEs should be able to attract increased capital from investors and improve core competence. At the same time, investors would value each business line of the company more, now that they understand the company better.

Only when the SOEs are open to such restructuring possibilities can they set up an effective monitoring mechanism over their lines of business and truly make each line strong and competitive on its own.

A successful SOE can only be built on the success of each of its own businesses and a successful Chinese economy relies on the success of each of its SOEs.