Check on China: Let the buyer be careful

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Chinese stocks are proving to be highly popular with small-cap investors, and the reason is simple: the Chinese economy is going to keep on growing.  And as with most investments, the key to cashing in is to beware of the minefields, and use common sense.

For a time it seemed as if the bull-run for Chinese stocks ended on February 27, when the Shanghai Exchanged dropped 8.8% in one day, to 2,581. The dip ignited fears that China’s phenomenal growth, which has recently averaged an incredible 10% a year, was coming to a screeching halt. However, two months later, the Chinese market has more than recovered, with the Shanghai Index topping 3,800 points (as of May 4, 2007), up more than 30% for the year. Chinese stocks listed abroad are also doing well.  The year-to-date gain for the Matthews China Fund (Nasdaq: MCHFX), a mutual fund basket of big- and small-cap Chinese stocks, is hovering around 10%, compared with about a 6% gain for the Dow Jones Industrial Average.

Despite this growth, many observers believe the Chinese stock market is a bubble waiting to burst (the Shanghai Index is up more than 80% from this time last year), pumped up by excess liquidity from Chinese investors mortgaging their homes in order to have money to invest.

My own view is that the market will not burst, but will almost certainly deflate before resuming its upward trend, albeit at a slower clip. The reason simply is that China will continue to grow (its GDP forecast for this year is for 11% growth). The corrections will come soon, as Beijing steps up its crackdown on the excess liquidity. On April 29, the People’s Bank of China, the country’s central bank, announced its fourth reserve requirement ratio (RRR) hike this year, by 0.5 percentage point, which brings the ratio to 11%. The RRR is the minimum amount of reserves each bank must hold to customer deposits and notes. The next round of tightening will probably come when the Shanghai Index gets close to the 4,000-point mark. 

As with any stocks, the obvious strategy for investors is to pick profitable companies that will grow from the corrections. With Chinese equities, however, comes the added burden of determining the validity of the information issued by companies in a system that is foreign to most Americans in every sense of the term. There is a common saying about the number of accounting books kept by some Chinese firms -- one for the government, one for company records, one for foreigners and one to report what is actually going on.

One commonly held assumption is that those Chinese firms traded on international exchanges, such as the New York Stock Exchange and Nasdaq, are somehow more trustworthy. After all, they got listed after meeting rigorous transparency and disclosure requirements. As we are all too often reminded, corporate malfeasance can occur in even the most tightly monitored and regulated circumstances, let alone those economic operating environments that might have looser controls.   

Another widely held assumption is that stocks in a particular sector will make for good investing opportunities because "such-and-such" industry is expected to grow at a double-digit rate. Here’s the problem with that rationale: in China, almost every industry is going to boom – whether it is energy, education, health care, or the toilet sector. Also, growth does not necessarily equate to profits. China’s massive bureaucracy and corruption could suck the life out of any business.  

The fates of two Chinese companies -- Suntech Power (NYSE: STP) and China Energy Savings Technology Inc (NASDAQ: CESV) -- highlight such risks. Both firms claimed to be well positioned for China’s booming alternative energy sector, and presented great-looking financials. However, only one company made money for investors. Suntech has become one of the NYSE’s best performing stocks, with a market cap hovering over $5 billion. On the other hand, China Energy Savings Technology is now under investigation by the Securities Exchange Commission for fraud, with the trading of its shares halted. According to the SEC, the firm fraudulently obtained its NASDAQ listing by artificially creating a shareholder base and falsely representing its minimum shareholder requirement. In an effort to pump its stock prices, the SEC accused the firm of issuing erroneous press releases and entering into secret deals to give free stock to shareholders willing to purchase in the open market.

So how can small-cap investors pick companies like Suntech without knowing Chinese and without visiting the firms in China? 

Three pieces of advice:

• Check to see whether the executives of the firms are experts in the industry they are in. Suntech Founder Shi Zhengrong is an authority in solar energy, holding 11 patents in the technology.  
• Examine the quality of the firm’s managers, who should not only have MBAs, but real experience. Suntech’s chief operating officer was formally with Deloitte Consulting. 
• Identify the firm’s venture capture and private equity investors. This is crucial because the global rainmakers all have a presence in China and have the resources to conduct their own extensive due diligence before putting their money and reputation on the line.  In fact, the big-money investors frequently hire private investigators to make sure the Chinese company and its managers are for real. 

It is no coincidence that Suntech’s VC investors included Goldman Sachs with its underwriters, Credit Suisse First Boston and Morgan Stanley. Such information should be in the Chinese firm’s foreign IPO prospectus.

This may seem like obvious advice. However, for China, it is the difference between getting burned by the hype or making money from it.

About the Author
Contributing author Ray Cheung has more than 10 years of extensive first-hand experience monitoring and analyzing social, political, economic and business developments in China. Read More

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