If one of your investments jumped 3,800% in less than a year how happy would you be? Ecstatic, probably. Now imagine how you would feel if 98% of these gains evaporated within a short few minutes. Utterly terrible, I’m sure. Well, that’s exactly what happened to shareholders in Hong Kong listed ArtGo last month – and there are a number of important lessons to be learnt.
Investors attracted to the significant gains that are theoretically possible in emerging markets really need to take note of the story about how a global index compiler lost its marbles. ArtGo is a miner, processor and distributor of marble stones from quarries in China. Its products include slabs for flooring and marble blocks for sculptures. There is little about the business to suggest it would be 2019’s superstar stock, but it was the biggest gaining company on global stock markets this year – until recently.
The power of indices
On 7 November, MSCI said it would include the shares in its suite of indices. Inclusion is a significant milestone for any business. Not only does it mean the company is being taken seriously, but it means tracker and index-based funds will buy the shares, creating demand and boosting its valuation.
But ArtGo shares shed $5.7bn (£4.4bn) of value in about ten minutes after MSCI was forced to scrap its plans following “feedback” from market participants. MSCI cited “serious” concerns about the company’s float and liquidity. The index group said it had received “comments from a range of market participants questioning the integrity of the publicly available float information”.
This obviously begs the question of how much due diligence MSCI did before the initial announcement of ArtGo’s inclusion. After all, these index compilers are now the gatekeepers for significant flows of money worldwide – the rise of passive investing in exchange-traded funds means investors are becoming ever-more more reliant on what they say and do.
As we learned with the way credit ratings agencies such as Standard & Poor’s and Fitch assessed mortgage-backed securities in the lead up to the financial crisis, this sort of thing really matters – and the decisions can have significant future consequences.
This is not the first time this has happened. Earlier this year we had a similar debacle – this time in shares of Ding Yi Feng. This company was included in the MSCI All-Country World Index in November 2018, but its shares ended up being suspended in March this year after they surged 8,500pc in five years.
The business was managed by a Taoist scholar, Sui Guangyi, who boasted investing skills on par with those of Warren Buffett. Multibillion-dollar funds run by the likes of BlackRock, Vanguard and Northern Trust had all piled into the shares following the nod from MSCI.
Trading in the shares was ceased after Hong Kong’s Securities and Futures Commission said it had been investigating suspicious trading in its shares since mid-2018 and called the share price “irrationally high.” At that time, it was valued at about 95 times the value of its net assets. Mr Sui’s company’s investment record is also something about which Mr Buffett would be likely to brag.
In response to the Ding Yi Feng situation, MSCI said it used “quantitative criteria” such as market value, free float, and liquidity when choosing companies for its indices and didn’t make judgments about profitability, growth prospects or “any other subjective” metrics. But, for investors, these are exactly the metrics that need to be considered.
More China exposure
Last week, MSCI completed the third and final phase of its 20% partial inclusion of China A-shares in its indices. These are shares of domestic Chinese companies traded on the Shanghai or the Shenzhen stock exchanges, not those listed in Hong Kong. From the close of play on Wednesday, the MSCI benchmarks included 472 China A-shares, made up of 244 large-cap and 228 mid-cap securities.
The changes mean that the MSCI Emerging Markets and the EM Investable Markets indices now have 29% of their investments in individual Chinese companies listed in Hong Kong and the mainland. Despite the veneer of investability that MSCI inclusion has given these companies, we do not know yet if there’s another ArtGo or Ding Yi Feng lurking beneath the surface.
In good times this may not matter so much, as a rising tide lifts all boats. However, as Warren Buffett famously noted: “Only when the tide goes out do you discover who has been swimming naked.” There is no doubt that the Chinese economy is facing serious difficulties and volatility in Chinese markets now looks inevitable.
Bad loans to companies are a serious problem but individuals are also increasing debts faster than their income, a party that cannot continue forever. The trade war is taking its toll on growth and the chances of a phase-one deal are now receding after Donald Trump signed the Human Rights and Democracy Act into law, stoking the ire of Beijing.
Much has been made about the benefits of low-fee passive investing. But, in many circumstances, you get what you pay for. In opaque frontier markets, active fund and investment management can really add value if they do the correct due diligence. Another blow-out such as ArtGo or Ding Yi Feng will be embarrassing for index compilers, as well as costly for investors relying on what they do. So, over the longer term, these companies – which effectively act as money funnels for global investors – must do better.
The above article was previously published by Charles Stanley on 2nd December 2019