China Upends Investment Logic

Conventional measures of value aren't much use when considering state-owned company mergers.

Sinochem and ChemChina may be challenging news reports that they are about to merge, but investors shouldn't ignore the message the potential combination sends. As the recent amalgamation of Baosteel and Wuhan Steel showed, reform of China's state-owned enterprises will create national giants by merging profitable companies with money-losing ones.

As a result, investors are faced with an unusual conundrum: Buy better-performing companies or bet on cheaper, ailing firms on speculation that a takeover will yield a one-time windfall. Traditional logic favors sticking to quality, but that rationale is turned on its head if top performers are repeatedly forced to swallow weak competitors. 

The different paths of bonds from ChemChina and Sinochem provide the perfect illustration:

What's Good Is Bad, What's Bad Is Good

Bonds of ChemChina subsidiary National Bluestar rallied while Sinochem's dropped after news of a potential merger

Source: Bloomberg

* Levels indexed to Sept. 29 for comparability.

Dollar-denominated securities of China National Bluestar, a ChemChina unit, climbed after the deal was reported, while those of Sinochem declined. As Gadfly noted on Friday, ChemChina lost 7.5 billion yuan ($1.1 billion) in 2015. The company's financial position is strengthened by being absorbed by a stronger, profitable competitor; the converse is true for Sinochem.

Even in China's stock market, which has tended to cheer both companies involved in any merger --regardless of which might be considered the winner -- gains have been uneven. When Baosteel and Wuhan Steel resumed trading in Shanghai on Oct. 10, after being halted for more than 100 days pending the deal announcement, the latter rose 21 percent in two sessions while the former (the larger and more profitable) increased 18 percent.

The Weak Win

Stocks of both steel companies rose after a merger was announced, but the weaker one outperformed

Source: Bloomberg

* Prices indexed to June 17 for comparability.

Clearly, it's better to be invested in the weaker party in a takeover, though the trick is in figuring out which companies are likeliest to be consolidated. It's a risky game: Pick the wrong target and investors could be fighting for scraps in a bankruptcy court rather than enjoying a bumper payday.

A case in point is Dongbei Special Steel Group. The company's local debentures (it doesn't have offshore debt) are trading at 40 cents on the yuan after it entered a restructuring that may result in creditors taking equity in the unlisted firm. That's an outcome that few would have predicted a couple of years ago given Dongbei Steel's 52 billion yuan of assets. 

The SOE reform has added another layer of complexity for global investors looking at China. Far from being a market-driven process in which the fittest will survive and thrive, the program resembles a politically driven leveling in which the strong are made weaker and the weak get stronger. Investors may need to discard conventional yardsticks of value until the restructuring is complete.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

    To contact the author of this story:
    Christopher Langner in Singapore at

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    Matthew Brooker at

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