A contrarian investment stance on China

The increasingly hackneyed growth stories about China and India (replete with a new phrase - "CHINDIA" - often a harbinger of hubris) seem to have become the staple diet of just about every investment conference in the past few years. The hype is rather reminiscent of the Y2K and TMT hoaxes that parted so many gullible investors from their money. Certainly, some eye-watering numbers on Chinas real economy can be flaunted, but attendees at these conferences invariably have to suffer crass extrapolations of the kind that in the sixties predicted there would be only standing room on the planet by now.

Some sobering Chinese realities:

China's economy is still centrally controlled (for example, a maximum PE multiple for IPO's was set in December 2001, with the result, predictable to all but the imposing authorities, of earnings manipulations, as had been the case when the Philippines introduced a similarly misguided initiative. Those listing the companies are obviously less inclined to lower the market capitalization and more likely to use imaginative accounting to inflate pro-forma profits).

The percentage of Chinese IPO's whose stated return on capital peaked in the year preceding the listing (and therefore before proper scrutiny by respected auditors and before fuller disclosure requirements) is 100%. (1)

In a similar vein, the change in net income margins of H shares in the four years following new listings has been a negative 40%. It would appear that new investors are being duped into giving credence to puffed-out pro-forma financial statements.

The annual new power generating capacity needed to sustain China's recent growth rate (and indeed the consensus expected growth rate) exceeds the entire installed capacity of the UK. Such tangible pre-requisites, easily enough discovered by induction, tend to escape the notice of forecasters who rely mostly on extrapolations of recent trends.

The need to repay bank loans is still perceived as optional since the central government has a habit of obliging defaulters, so listed companies' fiduciary responsibilities towards external, minority, western shareholders is unlikely to feature prominently in these companies' internal statements on corporate governance, if such statements exist.

The economic growth rate of China is often described as unprecedented, which is strange as these sorts of growth rates were also sustained by Japan (1950 - 1980) and by Hong Kong (1960 - 1995) (2)

Given the vastness of China and its massive population, accurate calculation of GDP must be more difficult than in most countries, yet each quarter China is among the first countries to release a GDP growth number. One could be forgiven for suspecting that rough estimations and smoothing might be used.

When a country is experiencing floods of capital inflows, it is not unusual for margins to become extremely suppressed. Ganzhou Honda (a joint venture with Honda of Japan) expects to make a profit per car of just eight Hong Kong dollars in 2008. In that case, maybe the fact that its car sales actually fell in 2006 came as a relief. (3)

Even investors loath to believe or to pay heed to any of the above need to consider an issue that they might normally take for granted: that of basic regulatory protection for shareholders. The following excerpts from the small print of an offering document for a fund (4) investing in Chinese equities may give them pause to reflect:

"...suitable for investors who are willing to withstand the total loss of their investment..."

"Companies quoted on Greater Chinese stock exchanges are exposed to the risks of ...expropriation of assets or nationalization"

"...the position with regard to PRX taxation ofgains and profits remains unclear"

"...Should any tax be payable retrospectively, the NAV will be adjusted to the extent that existing shareholders are liable".

This author is prepared, albeit reluctantly, to contemplate that he is wrong and/or misguided about the extent of Chinas economic growth, because that is actually less interesting to investors than the debate on the merits of buying listed Chinese shares. For that matter, it is less interesting than the even more frequently made case for buying developed market shares in companies, which are purported to be beneficiaries of what is happening in China. These usually fall into two groups: companies which source items made in China for on-sale in their own markets (Wal-Mart is often cited) and companies which have relocated their own production to China to benefit from the very low wages.  The problem with these cases, appealing as they are at first glance, is that they are very well known to the investment community! Therefore, any genuine benefits are likely to already be reflected in the associated share prices. In fact, the lessons of behavioural finance would suggest that because China is such a fashionable investment topic, any such benefits are probably already over estimated in prevailing share prices. In this context it is worth recalling the days when any mention by a company of a venture into e-commerce gave its share price a boost, and it is equally worth recalling the subsequent disappointments. Nowadays, the enablement of e-commerce by a company is ubiquitous.

Jonathan Anderson, Chief Asian Economist at UBS, has described the Chinese economy as: "propped up by a potent cocktail of free capital and distorted resource allocation. That sounds a lot like south-east Asia in the latter half of the nineties. And that episode also had its own nickname - Asian Tigers. Remember where that went?

Finally, the crazed rush by institutional fund managers to offer retail products investing in Chinese equities, BRIC's, BRICK's and BRICKS (5) should sound the largest alarm bell of all.

(1) Marathon Asset Management

(2) UBS

(3) Goldman Sachs

(4) Martin Currie Investment Management

(5) Brazil, Russia, India, China, Korea and South Africa.