Adventurous Investor

June 11, 2010 6:23 pm

Chinese small caps still come with big risks

David Stevenson: A London-listed fund that invests in private equity deals in China

If you read last week’s column about my trip to China, you might think that I’m enormously bearish about Chinese stocks. And, to be fair, I’m not entirely convinced. In my view, a small single-digit allocation to Chinese equities will probably suffice – and you need to be careful how exactly you structure that investment. I suspect you need exposure to large caps through a cheap tracker fund, plus stockpicking funds operating in the consumer, clean tech and services sectors.

But I have now found a London-listed fund that invests in smaller, even earlier stage companies plus private equity deals in China and the rest of Asia.

It’s called Origo Partners and has just announced a fundraising through the placing of new ordinary shares that will aim to raise $30m (£20.7m) to put into “well advanced investment opportunities”.

It’s managed by Chris Rynning – a veteran China hand – and its approach is fairly unusual: private equity deals focused on small, private clean energy and resources companies that might move to an initial public offering (IPO), with some heavy bets on the frontier market of Mongolia. It sounds very risky but with the shares trading at a hefty discount to net asset value (NAV), a cash pile equivalent to a quarter of that NAV, and the likelihood of two big IPOs in the next 12 to 18 months, I think there is a decent margin of safety.

Most importantly, I like its boss’s cautious approach. “I maintain a healthy scepticism regarding Chinese small caps and their founders,” says Rynning. “Unless you have a team of loyal accountants and lawyers on the ground performing due diligence and constantly monitoring the companies, small cap investing in China is an extreme sport that I would not recommend to the inexperienced. If you can master it, however, opportunities abound.”

This is exactly the attitude I would expect from sensible foreign- backed equity managers based in China. Corporate governance is still dreadful and one leading analyst I talked to said it was getting worse as more money flows in. Another fund manager told me that his desk drawer contains undated letters of resignation signed by the CEO and CFO of a Chinese company he invests in – in case it all goes pear-shaped and he has to grab control of his investment!

Even so, there’s still lots of money to be made in China, mainly because the local banks won’t lend properly to private small cap businesses in China – a hideous inefficiency that must be fixed in the long term. Also, the Chinese equity market is still growing at an extra-ordinary rate in volume terms and, on some measures, isn’t hideously expensive. According to aggregate data from French bank Société Générale, the Chinese equity market trades at 11.9 times 2010 estimates for earnings, falling to 10.1 for 2011, with earnings per share growth of 29 per
cent in 2010 and 17.9 per cent in 2011.

I have a strong sense that most growth will come through the small cap sector – and Origo’s focus on clean tech companies, plus its
growing stable of yuan-denominated venture capital funds, should be able to capture much of that upside.

Of course, all the talk of opportunity and geo-political potential must not blind UK investors to the risks of investing in small caps shares in some of the riskiest markets on earth. But I do find some re-assurance in Origo’s near 40 per cent discount to NAV. A report in April by analysts at Liberum put the NAV at around 37p, with $24m or 7.5p in cash on the balance sheet, versus a current share price of 27p. Liberum, perhaps optimistically, reckons that Origo’s stake in one company – Gobi – could even be worth 27p on its own if it lists this year or next.

Add in a likely IPO from an Australian farmland investment – RM Williams Agricultural Holdings – plus the possibility of more renminbi-denominated local equity funds in the pipeline (managed by Origo Partners for a fee), and I think there’s some safety in the numbers.

adventurous@ft.com

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