Anti-Corruption Drive Broadens With Lianhua Probe

Lianhua exec comes under investigation

In a development that many would say was widely expected, Beijing’s recent campaign to root out official corruption at state-owned companies is spreading deeper into the system, with word that an executive from grocery chain operator Lianhua Supermarket (HKEx: 980) is under investigation. I don’t normally follow Lianhua, as it’s a distinctively second-tier company that operates unimpressive grocery stores that are usually mostly empty whenever I happen to shop there. But that’s exactly why this particular probe is interesting, as it shows that the anti-corruption campaign is moving beyond the high-profile biggest state-run companies that have been targeted so far and into the smaller firms that populate the big majority of China’s corporate landscape.

According to Lianhua’s announcement, former high-level executive Dao Shurong is currently being investigated by the State-Owned Assets Supervision and Administration Commission of Shanghai. (company announcement; Chinese article) No further details were given, but this kind of investigation has become quite common in recent months and usually involves allegations of corruption by officials at big state-run companies. Lianhua shares have dropped around 5 percent in the last 3 trading sessions since the news came out.

The relatively mild nature of the sell-off shows that investors are slightly concerned about the investigation, but that their worries are relatively limited. That’s because top officials at many Chinese state-run firms often don’t play a critical role at the companies and are usually interchangeable. The Communist Party often uses such firms, as well as other government agencies, as training grounds for officials and moves them around from organization to organization every 3 or 4 years on a rotating basis. Thus few such officials are ever critical to the operations of a company.

From a broader perspective, this particular case is most interesting precisely because it targets a mid-tier company like Lianhua, which has a market capitalization of just under $1 billion. Up until now, officials that have come under investigation have been mostly from the biggest state-run firms like cellular leader China Mobile (HKEx: 941; NYSE: CHL), oil giant PetroChina (HKEx: 857; Shanghai: 601857; NYSE: PTR) and Chalco (HKEx: 2600), China’s largest aluminum producer.

In most of the bigger cases, big central government organizations in Beijing, most notably the powerful National Development and Reform Commission (NDRC), have led the corruption probes. In this latest case, the investigation is coming from a Shanghai-based body. That means that we’ll probably see more and more locally-based agencies start to take the initiative to join this anti-corruption campaign by targeting the many smaller state-run companies throughout China. It’s not surprising that Shanghai is one of the first cities to follow the NDRC’s lead, since it’s China’s commercial capital. But I expect we’ll start to see more similar probes soon from other major and second-tier cities.

So, what does all this mean for investors? The Lianhua example is probably a good one of how things might play out for future investigations. Investors will initially be worried when new probes are announced, causing a company’s stock to fall between 5-10 percent. But then people will slowly realize that each case is isolated and probably won’t affect the company’s broader development, allowing the share price to stabilize and resume its previous trends. Frankly speaking, most of these companies were never very interesting to me anyhow, as few have the commercial instincts they will need to survive in the competitive markets of the future. Thus most of these companies are likely to fail over the longer term, and purging them of corrupt officials will do little to change that destiny.

Bottom line: A new probe of an official at Lianhua Supermarket shows that Beijing’s anti-corruption campaign is spreading to mid-sized state-run firms, and will have some impact on their stocks.

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