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From day one, the tantalizing prospect of 1.3 billion potential customers
has loomed very large. Every investor, entrepreneur, and promoter has
looked at the size of the Chinese market and seen staggering profit potential.
The astonishing growth of the Chinese economy over the past two decades
seems to assure success.
If only it were that easy. Just as you might find anywhere, there are
good and bad companies in China. And there are entire segments of the
Chinese industrial colossus that should be "no go zones" for prudent investors.
Above all, watch out for the "ugly": Crooked stock promotions designed
to suck your investment dollars into a bottomless black hole. The good,
the bad and the ugly all rely on the Chinese mystique to lure investors.
The Good
Even the best of the good guys in the Chinese investment picture provide
no guarantees. Some of China's finest companies are in the oil industry,
and they share a captive consumer market. But that doesn't mean they are
all profitable. Nor does it mean that their stock prices will always rise
along with the phenomenal growth of the Chinese economy. Nothing is ever
that simple in the People's Republic of China (PRC).
Consider the behemoth known as PetroChina (PTR). PetroChina produces
fully two thirds of China's oil and gas. It is widely diversified in the
petroleum industry with a massive stake in domestic exploration, crude
oil and natural gas extraction, pipelines, refining, petrochemical production
and retail distribution at the pumps. Almost every aspect of PetroChina's
business is expanding robustly. Oil and gas production is exploding, and
refining capacity is operating near a peak, absorbing almost the entire
company's production of crude.
As a fully integrated oil company with a huge national presence, PetroChina
has a network of more than 17,000 service stations. Revenues grew by 28%
last year to $57 billion. Over 5 years, revenues have grown by an average
of 17%. That's a very impressive track record.
Looking more deeply into the metrics of PetroChina compared to those
of its competitors, we see that the company's revenues are less than half
those of ConocoPhillips. So how can it be that PetroChina has the greater
market value? PetroChina has a market cap of $138 billion compared to
$89 billion for ConocoPhillips!
The answer is in PetroChina's amazing margins. PetroChina boasted a profit margin of 36.5% in the past 12 months, compared to a 12.4% margin for ConocoPhillips.
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That sounds like a slam-dunk investment choice if there ever was one, but not so fast. From early May to mid-June of 2006, PetroChina shed almost a quarter of its value, off from a high of $123 to just $90. What went wrong?
From a long-range perspective, absolutely nothing is wrong with PetroChina. Even the best Chinese companies are volatile by the standards of North American big cap stocks. Why, partly because trading volume is light, averaging only half a million ADR shares per day on the New York Exchange. ConocoPhillips, which has a smaller market capitalization, has a volume ten times as large as PetroChina. |
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In practice that means small bumps in the road hit PetroChina harder. In May of 2006, emerging markets were shaken by interest rate increases and a pullback in some commodity prices. PetroChina suffered another setback when the Chinese government failed to raise the price ceiling on refined oil products as much as oil companies had hoped. The stock took a serious tumble.
Does that mean that even good stocks in China are too dangerous for the
average investor? Not if the investor has good financial guidance. In
the long run, PetroChina has been a fabulous investment. In five years
PetroChina ADRs (American Depository Receipts) have risen from a listing
price of less than $20 to a peak of $123. Early investors have had something
of a bumpy ride but, it was well worth it.
Another place we see the enormous scale of the Chinese consumer market hard at work is the wireless telephone industry. China's cellular phone market has grown to a truly breathtaking size. 420 million Chinese people have cell phones, and at least five million new subscribers are added every month throughout the country.
The biggest of the wireless companies is China Mobile (CHL) with more
than a quarter of a billion customers. Surprisingly, China Mobile has
a market capitalization only a little bit larger than a comparable American
company like Verizon Communications (VZ).
The reason in a nutshell that China Mobile hasn't far outstripped Verizon
is the relative wealth of the two companies' markets. As big as it is,
China Mobile has revenues of approximately $30 billion a year. Operating
from a smaller but much richer customer base in the United States, Verizon
has revenues of almost $80 billion.
Does this comparison show that China Mobile is a poor stock pick? Not
at all. The company is still growing and adding services to enhance its
revenue stream from its existing customer base. The future is promising,
and one major business magazine recently ranked China Mobile as number
eight in a ranking of the top 100 technology companies on the planet.
The rapid expansion of telecom services also serves the Chinese government's
ambitious goals. The government plans to turn China into a major Asian
hub for telecommunications and information services. That may be something
of a challenge given China's insistence on state control of information
flow. Nevertheless, we expect the Chinese telecom industry to continue
to outpace the overall economy growth. China's telecom market is now growing
at an annual rate of 17 %, almost twice the pace of overall economic growth
according to Ministry of Information Industry of China.
Unlike other China stock watchers, we include Taiwan in our view of so-called
"Greater China." Taiwan has a much longer history of managing a capitalist
economy, and we appreciate companies that are less tied to state control
than some colleagues in the People's Republic of China (PRC).
Chunghwa Telecom of Taiwan is a good example of that kind of company.
Formerly a government directorate, Chunghwa was spun off in 1996, holding
an immense legacy of Taiwanese customers and an international infrastructure,
an advantage that the company holds over competitors in Taiwan's telecommunications
market to this day.
Chunghwa's hold on 98% of Taiwan's fixed line telephone customer base
shows the depth of the company's penetration and its grip on the domestic
market. The Company's principal services include fixed line services,
including local, domestic long distance and international long distance
telephone services. Chunghwa is a major player in wireless services, including
cellular and paging services and Internet and data services.
Chunghwa's financials show a company that remains conservatively priced
with a P/E just under 6. Obviously the market does not expect Chunghwa
to expand dramatically, but shares have risen more than twenty percent
over the past two and a half years. Even better, the company generates
an annual 8% dividend.
INVESTING WITHOUT A NET
In general, we prefer to invest in companies that do generate dividends.
Dividends are a sign of stability, dependable cash flow and they tend
to smooth out the volatility of emerging market stocks to provide investors
with greater stability and more reliable returns.
Chinese Internet based stocks generally do not fall into our value investing
model. It is true that there are estimated to be 100 million Internet
users in China, and that number is probably an underestimate. The sector
is expected to bring in about $2 billion in revenues this year. But, by
Chinese standards, these are very small numbers. Our analysis indicates
that the sector is too immature and unstable to warrant the inherent risks.
The fantastic claims made by some Chinese Internet stock promoters do
not stand up to serious scrutiny. Let's take a look at some examples:
eLong (LONG) is an Internet travel service which has enjoyed a rise from
a 52-week low of $8 to a current value in the $14 range. There's nothing
wrong with a 50% gain in one year, but look a little closer. The share
price is off sharply from its $24 price peak at the company's IPO in the
fall of 2004. Its volatility is hair-raising.
In its most recent earnings report the company touted a 53% revenue increase
in the previous quarter, and shares rose almost 12% on the news. These
sound like impressive gains, but the hard fact is that eLong lost money
last quarter, and it lost $0.31 per share in the past year. So much for
revenue big increases. eLong's P/E ratio is non-existent because the company
earns no profits. Nevertheless, it sports a market cap of $350 million!
Performance like that is too similar to the American Internet bubble for
comfort.
Let's take a look at another big player: Shanda Interactive Entertainment
(SNDA). The description of this company sounds fantastic: Shanda Interactive
Entertainment (SNDA) is the largest Internet game company in the People's
Republic of China. Shanda offers a portfolio of online games that users
play over the Internet. Its main revenue source is a selection of five
"massively multiplayer online role-playing games", known as MMORPGs. Shanda's
MMORPG games allow thousands of users to interact with one another in
a virtual world created on the Internet. The games are reported to be
almost addictive, and players must pay a monthly subscription fee to sustain
their game characters and ongoing roles.
Shanda controls 50% of this market and is able to accommodate more than
a million players interacting simultaneously. But its shares are in a
nosedive. Just over a year ago, Shanda's shares peaked above $40 as the
popularity of Internet games grew. But tastes change, and free games are
now becoming more popular in China.
Shanda's shares are now priced in the $12 range, yet the company still
carries a market cap of almost a billion dollars and no P/E ratio because
it registered a loss in the most recent quarter.
What about the earnings increases that you may be hearing about from
Internet stock promoters? Consider one of the top performers, Baidu.com
(BIDU). Baidu wants to be the new Google in China, and it reported a 306%
increase in income last year. So far that sounds spectacular. The company
has a market cap above $2 billion dollars. Who wouldn't want to own the
next Chinese Google at that price? We wouldn't, at least not now.
Baidu's tremendous growth in earnings has in reality raised net income
from $1.5 million in 2004 to just over $6 million in 2005. High percentage
gains seem a lot less impressive when the numbers involved are relatively
tiny. With such a small earnings stream, Baidu's P/E ratio is a truly
death-defying 272! Despite earnings increases, Baidu shares have lost
almost a third of their value since their frenzied IPO almost two years
ago.
Enthusiasm about the future of the company was further dampened recently
when Google announced that it would sell its small stake in Baidu. That
move killed rumors that Google was planning to take over its competitor
in the Chinese market. Instead, the two will go head to head.
NOT ALL INTERNET STOCKS ARE "BAD"
To be fair, not all Chinese Internet stocks are money losers.
One of the most successful Internet stocks on the Chinese scene is Netease.com
(NTES). NetEase aspires to be the Chinese version of Yahoo, and it does
have real income, exceeding $127 million last year. With a market cap
of almost $3 billion, we remain cautious about even these "success stories"
on the Chinese Internet scene. After all, NetEase shares are highly leveraged
with a P/E above 23 and there is no dividend.
NetEase has risen from a split-adjusted value of $14 a share to $22 in
the past 52-week period. But what a ride it has been. Exhibiting the volatility
characteristic of many emerging Internet stocks, NetEase shares lost as
much as 25% of their value during a single rough week last year.
The company also depends on games for a portion of its revenues. That
means its revenues are subject to the vagaries of fashion and teenage
gaming whims. Some investors may be at ease with this risk/reward profile,
but it is not part of our model at the China Stock Digest.
GigaMedia Ltd. (GIGM) of Taiwan has seen a rise in share value of almost
200% this year. But is it also skating on thin ice? The company, whose
products include Everest Poker and the FunTown gaming portal, reported
in its most recent quarter that net profit soared and share prices responded.
But keep in mind that total profits were a scant $3.2 million, or 6 cents
per share, up from $1.02 million, or 2 cents per share, a year ago. Despite
its slim profit stream, GigaMedia have a market cap of almost half a billion
dollars and a PE greater than 50. We see that as pure speculation.
SECTORS TO WATCH OUT FOR
The Chinese government has produced a guide to economic sectors that
are overheated and headed for restructuring. The National Development
and Reform Commission (NDRC) is the nation's top economic planning agency,
and it has targeted a number of industries that are suffering from overcapacity
and due for a correction. Some might surprise you.
The cement industry has done extremely well in North America. Investors
might expect that China would have an even greater need for basic building
materials given the incredible amount of construction going on there.
Cement output grew by ten percent last year, and that was far too much
according to the NDRC.
The commission plans to reduce the number of cement companies from more
than 5,000 to 3,500 by 2010. The oversupply of cement and cement companies
is one example of the effects of overinvestment in a fast-growing economy.
The Chinese entrepreneurial spirit is strong, and too many cement companies
were established in anticipation of unlimited growth. The industry's restructuring
will be painful.
Aluminum production capacity in China is also far above demand. Last
year the industry produced only eight million tons of aluminum although
smelters could have produced more than ten million tons. The industry
investment boom is still not under control, and the NDRC believes that
smelting capacity will reach an astonishing thirteen million tons. The
commission plans another major restructuring and consolidation of this
industry.
The manufacture of raw steel (ferro-alloy) is also facing a cutback.
China's production capacity of ferro-alloy is more than twice what is
required by the economy, almost certainly a hangover from the days of
giant state owned enterprises (SOEs). The commission plans to chop off
25% of the nation's production capacity, leaving the remaining facilities
in place in case continued economic growth absorbs the rest of the excess.
Another glaring example: Most producers of coke are losing money and
will never break even. Coke is the coal-based fuel used to generate high
temperatures for steel production. Eighty percent of coke producers are
losing money, and most small production facilities will be shut down by
2010.
However, the coal industry is one sector that will continue to expand
as energy demand increases relentlessly. The government plans to increase
coal production more than 10% by 2010. The production target is a staggering
2.45 billion metric tons.
The problem is that there are many small and inefficient producers, and
some of them are responsible for the rash of accidents that continues
to plague the coal mining industry. The powerful NDRC aims to concentrate
the bulk of the industry in the hands of a few mining giants. This is
an industry which requires massive scale and efficiency. Therefore we
suggest you be wary of recent penny stock promotions in North America
trying to sell shares in smaller firms in the Chinese coal industry.
PROFITS IN PENNIES?
Above all, we encourage readers to be cautious about Chinese penny stocks.
Look out for companies the are traded on Pink Sheets or as over-the-counter
"Bulletin Board" stocks (You will see PK or BB in the stock's symbol for
this category of stock.
Some entrepreneurs are capitalizing on the Chinese stock boom by conducting
what they call "reverse mergers." A reverse merger allows a stock promoter
to sell shares in a Chinese company without the usual legal and regulatory
formalities. It works like this:
The promoter begins by looking for a home for his Chinese venture, perhaps
a defunct silver mine far from the prying eyes of any investment firm
that might wish to conduct due diligence. Next, the promoter finds a defunct
American company that is still tradable on U.S. soil. Buying the American
firm for next to nothing, the promoter then instructs the American shell
to purchase the Chinese venture.
After that, all if takes is a bit of paperwork and a name change. A defunct
technology firm in California can be transformed into a Chinese mining
firm and marketed to investors. Of course the promoter sells out after
he has made a profit, and the remaining stockholders are left holding
what may be an empty and worthless shell.
WHAT TO DO NEXT
The rules are simple and they boil down to a few guidelines. Stay away
from speculative ventures, penny stocks and emerging market stocks on
the Pink Sheets.
Stick to ADRs which trade just like stocks on the New York Exchange and
the NASDAQ.
Finally, don't go it alone. Consult a professional financial advisor,
a CPA or a respected source before you venture into any emerging market.
You'll need help to tell the "Good" from the "Bad and the just plain "Ugly."
Remember, only a fraction of China's 1.3 billion consumers have made it to the middle class. On average, a Chinese family brings home less than $2000 a year. So the captive market within China is not as large as it might seem. Do not be fooled by the dream that 1.3 billion customers will make any Chinese investment a sure thing. |
