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China's Industries: The Good, The Bad and The Ugly
From day one, the tantalizing prospect of China's 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 has created a gold rush
mentality among new China watchers who seem to believe anything
Chinese is assured of investment 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 are bad news "no go zones" for prudent
investors. Above all, watch out for the "ugly": over-hyped sectors and
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.
Industry Overview
In a mere 20 years China has transformed itself from a state
run economic disaster to a successful practitioner of bare-knuckled
capitalism. Yet, the Mainland China of today resembles the
1870's industrial revolution America. Just as America experienced
its challenges with child labor, environmental damage, workers
rights and safety, and under-regulated financial markets,
so too does the China of today.
My knowledge and opinions come from over 20 years of experience
in the financial industry. I've spent the greater part of
my career studying the ins and outs of the Chinese
economy and have traveled there many times over the years.
My understanding of China comes from first hand experience,
not from reading a book. To get us started, let's explore
the following chart, which summarizes the sectors of China
in terms of investment access and viability of local Chinese
enterprises available to U.S. investors. Please keep in mind
that the material you are reading comes from our archives,
and some numbers no longer apply.
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Investment Access & Viability
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Basic Materials (includes Chemicals, Commodities, Oil, & Steel) -
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Good
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Communications & Utilities (mobile & land line telephone & electric) - |
Good
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Technology (software, diversified electronics, semiconductors) -
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Good
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Consumer Goods (includes appliances, car makers, food, home furnishings, personal products) -
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Limited
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Financial (banking, insurance, real estate) -
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Limited
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Services (advertising, consumer services, restaurants, staffing) -
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Limited
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Healthcare (biotech, drugs, hospitals) -
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Poor
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Industrial Goods (defense, construction machinery, machine tools) -
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Poor
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Good Access
The Oil and Energy Sector Features Strong Companies Judged
By International Standards
Some of China's finest companies are in the oil & energy industries. They share a captive consumer market, and many are scouring the world to acquire new resources. 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).
Example:
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.
PetroChina has a network of more than 17,000 service stations. Revenues grew by 28% last year to $57 billion. Over five years, revenues have grown by an average of 17%. That's a very impressive track record.
This might sound 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 happened?
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? In part, it is because trading volume is relatively light, averaging only half a million ADR shares per day on the New York Exchange. That means small bumps in the road hit PetroChina harder.
PetroChina suffered another setback when the Chinese government
failed to raise the price ceilings on refined oil products.
Government intervention is always a factor in China.
Does that mean that even good stocks in China are too dangerous for the average investor? Not if the investor has good financial guidance and patience. Investors can only admire the long range view of PetroChina's performance.
Communications Enjoys Phenomenal Growth in China's Customer
Base
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.
Broadband Internet access has spread like wildfire. China's
broadband user base grew to more than 35 million subscribers
by the end of last year, a staggering increase of 52% year-on-year
according to the IDC research firm.
Example:
The biggest of the wireless companies is China Mobile (CHL) with more than a quarter of a billion customers. As big as it is, China Mobile has revenues of only $30 billion a year. By comparison, operating from a smaller but much richer customer base in the United States, Verizon has revenues of almost $80 billion.
Nevertheless, the future is bright. The Chinese government plans to turn
China into a major Asian hub for telecommunications and information services.
China's telecom market is now growing at an annual rate of 17 %.
Taiwan Is A Major Player In Communications and Technology
Unlike other China
stock analysts, we include Taiwan in our view of so-called
"Greater China." Taiwan has a much longer history of managing
a capitalist economy than the Mainland, and we appreciate
companies that are less tied to state control than some colleagues
in the People's Republic of China (PRC).
Example:
Chunghwa Telecom of Taiwan is a good example of this kind
of company. Formerly a government directorate, Chunghwa holds
an immense legacy of Taiwanese customers and an international
infrastructure. Chunghwa's grip on 98% of Taiwan's fixed line
telephone customer base provides a stable platform for growth
into wireless and broadband Internet services.
Chunghwa's financials show a company that remains conservatively priced
with a P/E just under 6. 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.
Technology, Good Access On A Global Scale
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Many westerners still think of China as a source of cheap consumer goods such as toys and textiles. But the picture is changing. A recent Deutsche Bank analysis shows that Chinese exports of sophisticated products such as vehicles, car parts, electronic equipment and telecommunications equipment are growing more quickly than sales of cheap commodity goods.
Taiwan
has a head start in semiconductors and telecom equipment,
and boasts one of the largest chip foundries in the
world. It is so important that a Taiwanese earthquake
several years ago disrupted semiconductor markets worldwide.
Mainland China is still lagging in this field even though it is graduating record numbers of engineers who could help build a much larger software and high tech hardware infrastructure. The shortfall is partly of China's own making. Due to notoriously poor intellectual property enforcement, many high tech entrepreneurs within China are now complaining that they can't raise the revenues they need domestically in order to compete internationally.
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The Goods On Consumer Goods
Growth in this sector has been phenomenal, but investment opportunities remain very limited.
The Chinese automobile industry is probably the most famous in this
sector. Sales of passenger cars have more than tripled since
2000 and stories about air pollution and crowded roads in
China have become commonplace.
The shock felt around the world happened in 2008 when the
two Chinese car companies went public with their plans to
introduce ultra-low priced Chinese cars to the North American
market. These sub-compacts, the Geely and the Chery are expected
to sell for less than $10,000.
This may sound like a great growth opportunity for investors,
but not so fast. Almost all of China's major carmakers are
still bloated state owned enterprises (SOEs). The good news
is that most carmakers have built alliances with multinational
auto companies, and they are learning the ropes of efficient,
high quality industrial production. The Chinese government
knows that most SOEs are not fit for international market
listing until they meet world standards.
The same is true of other consumer companies such as appliance makers.
They are still emerging from the shadow of communist central rule and
reaching out for worldwide partnerships and even takeovers.
Banking On Financial Stocks
China's banks are bursting onto the world scene with a truly
historic flourish. The biggest event was the IPO (Initial
Public Offering) of the Bank of China on markets in Hong Kong
and Singapore. It was the biggest IPO in the world in 2008,
and more Chinese banks are preparing for international listings.
As big as they are, Chinese banks are not without considerable risk.
Many are riddled with bad loans issued to prop up insolvent state corporations
under direct orders from the government.
China's real estate sector is also on shaky ground. Years
of intensive investment and construction have created a glut
of houses and apartments too expensive for the average Chinese
consumer. This building boom is still underway, and the bubble
has not yet burst. The Chinese government is ratcheting up
interest rates and struggling to put the squeeze on real estate
lending, but there is a real danger that the explosion of
the real estate bubble could also hurt Chinese banks.
China's insurance sector is emerging, and there are investment opportunities.
There is a real and growing need for insurance products (pensions and
annuities) among Chinese consumers who can no-longer look to the government
for cradle-to grave security from the Communist Party.
Services For Investors
Service industries are growing very rapidly. China is currently
experiencing a tourist boom that can only grow larger as the
result of the 2008 Beijing Olympics approach. But few major
tourist facilities have hit the market as "pure"
China
investment plays.
As with so many important industries, the service sector is slowly emerging
from the shadow of central government ownership, and investment
opportunities are very limited. Private entrepreneurship seems
to be taking the lead in this sector as fledgling advertising
agencies such as Focus Media (FMCN) have sought NASDAQ listings.
Judging the Health of Healthcare
Again, access is limited to this sector because most traditional healthcare
investment vehicles are still in government hands. We know of only one
privately owned hospital company in China: Chindex (CHDX), which is undergoing
start up challenges.
Biotech is a breathtakingly risky field in any nation. Two
of China's five listed biotechs deal in traditional Chinese
herbal remedies and foods which now go under the more respectable
name: nutraceuticals. There may be more stability and future
strength in the few listed companies that deal in laboratory
equipment, and hepatitis vaccines.
IS INVESTING WITHOUT A SAFETY NET (THE BAD?)
In general, we prefer to invest in companies that 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 have brought in about $2 billion
in total revenues in 2008. But, by Chinese standards, these
are very small numbers, split among many providers.
The fantastic claims made by some Chinese Internet stock promoters do
not stand up to serious scrutiny.
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 big revenue increases.
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 Shanda offers a portfolio of online games that users play over the Internet. 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.
PROFITS FROM UGLY PENNIES?
Above all, we encourage readers to be cautious about Chinese penny stocks. Look out for companies that are traded on Pink Sheets or as over-the-counter "Bulletin Board" stocks (You will see PK or BB in the stock's symbol if it is one of these).
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."
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