Why China Could Disappoint Investors

Everyone loves to ride a hot trend, but in too many cases, the hysteria is much bigger than deserved.

When it comes to hot trends, it's hard to come up with a hotter one than Chinese stocks. But as I see it, the "invest in China" craze has reached irrational proportions, and it's time to start paring any picks specifically intended to capitalize on the Far East's alleged surge in consumerism.

The rest of the story
It's hard to argue that China hasn't been an investment-worthy spot in recent months. The country's nearly $600 billion in government stimulus occurred almost entirely in the first half of the year, and the Chinese economy has responded quickly. China's annualized gross domestic product growth during the second quarter rolled in at 7.9%, topping previous estimates of 6.1% by a wide margin.

The fiscal strength trickled into stock prices, too. The Shanghai Composite has risen 65% so far this year, handily beating results in the U.S. and most of the rest of the world.

Yet to understand China, you have to look beyond government spending and stock prices to the underlying economy. Take a look at some of the data suggesting China's consumers aren't faring as well as the country's industries:

  • The official "urban unemployment" rate of only 4.3% sounds wonderful, but it doesn't consider the 60% of the country's residents employed in the private sector.
  • According to one government official, around 3 million recent college graduates in China -- roughly a third of the total -- can't find work, 30 million previously employed workers lost their jobs late last year, and about 2 million migrant workers remain out of work.
  • Yes, China's banks are lending, but that's likely because the government is strongly urging them to lend. In the first half of the year, lending was up 28% to more than $1 trillion, but does higher lending make sense with high unemployment? Keep reading ...
  • The People's Bank of China recently said nearly 5 billion yuan (about 730 million U.S. dollars) in credit card debt was more than 60 days late for the first half of 2009, an increase of 133% from the year-ago period.

Those are hardly signs of healthy Chinese consumers.

Tightened purse strings
I don't want to imply that tepid consumerism in China is a permanent condition. It's simply a condition that hasn't gotten better yet, and I don't see any real catalyst on the horizon to improve things.

For instance, look at Yum! Brands (NYSE: YUM  ) and its recent results. Its China division posted an 8% increase in revenue last quarter thanks to new store openings, but same-store sales in China were actually lower by about 4%. That's not good news, given that China accounts for more than 30% of the company's revenue. Profits and margins have held up well thus far, but it's uncertain whether the company's big investment will keep paying off as an influx of outside investment saturates the consumer market.

Yet companies continue to invest in China. Coca-Cola (NYSE: KO  ) has accelerated its Chinese investments with a $2 billion initiative to build new bottling facilities and make Coke products more available. Last year, PepsiCo (NYSE: PEP  ) announced a similar $1 billion investment program in the country over four years. Yet if the Chinese won't spring for a little fried chicken, are bottled beverages somehow going to fare better?

The beverage makers aren't alone. Ford's (NYSE: F  ) auto sales in China rose by 14% in the first half of 2009. But with Chinese consumers having trouble paying credit cards, can they afford car loans? Similarly, Advanced Micro Devices (NYSE: AMD  ) relies on China for more than 40% of its revenue, while companies like Starwood Hotels (NYSE: HOT  ) and cosmetics retailer Elizabeth Arden (Nasdaq: RDEN  ) both need consumers to step up and spend. It remains to be seen whether the investments these companies have made to expand their presence in China will pay off.

Getting back to work
My point is that for China's consumers to really start spending again, a lot more of them have to find jobs. But that may not happen anytime soon. Although some argue that a global rebound will spur Chinese job growth, I'm not so sure now.

Fed Chairman Ben Bernanke has said the U.S. recession is very likely over, yet unemployment here remains at multiyear highs. Moreover, despite all the green shoots, China's exports were down 23% for August, compared with last year. That doesn't bode well for a Chinese hiring spree, and poses the possibility of a true jobless global recovery.

From the way share prices have jumped, though, it's apparent that investors are counting on China paying off in a big way. That makes U.S. consumer stocks with big China stakes heavy on risk now. With prices already assuming China will keep performing well, shareholders should look out below if actual results fall short of those lofty expectations.

Related Foolishness:

Coca-Cola is a Motley Fool Inside Value pick. Coca-Cola and PepsiCo are Income Investor picks. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor James Brumley doesn't own any of the stocks discussed above, but if he did, you'd know about it in accordance with The Motley Fool's disclosure policy.


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  • Report this Comment On September 18, 2009, at 10:25 AM, Timinburg wrote:

    I have just moved from China back to the U.S. and have a basic understanding of how Beijing doesn't connect the dots. In the article it states the urban unemployment rate is in the 4's% and does allow for the fact that the private sector is not scored. The official data is based upon official demographics and therein lies the true rub. A city such as Guangzhou or Shenzhen claim an official population of around 8 million people.... however it's actually 50% higher with the unregistered migrants. With the opening of society and "looking the other way" Province officials let job seekers go where they have a chance to find employment.

    I think Mr. Brumley has identified a core problem but it is much more vast than what we see. Social unrest is China's biggest concern and they have plenty of it already..... Beijing is most concerned.

  • Report this Comment On September 19, 2009, at 6:07 PM, ChicagoGrad wrote:

    This author says "But with Chinese consumers having trouble paying credit cards, can they afford car loans?" Well, what he avoids mentioning is that only about 10% of Chinese even own credit cards. He also fails to mention that 90% of cars (and 50% of homes) in China are paid for in cash. Most Chinese people simply don't believe in buying on credit. In general, the people in China that have credit cards are relatively wealthy, and just like the wealthy here in the US, many live beyond their means. To act as if this spending behavior is typical in China is disingenuous at best.

    The average worker in China saves over 25% of everything they earn, and that figure even includes the factory worker earning $100 per month. Of course, this freakishly high savings rate does have a slowing effect on the Chinese economy. All American companies have to do is convince Chinese consumers to recklessly spend just like their American counterparts.

    As for the decline in same store sales for YUM, that is mostly because the fad of Western-style fast food is starting to fade, but it is also because KFC and Pizza Hut are very expensive by Chinese standards. A typical meal for one person at KFC will cost between $2-3, which is enough money to feed an entire family in many restaurants.

  • Report this Comment On September 21, 2009, at 12:14 AM, ET69 wrote:

    Having lived in Japan for many years and spent extended stays in China many times a couple of observations are in order. Even if their economic growth continues most Asians will continue to save what ChicagoGrad calls "freakish" amounts of their income. Its a cultural influence based upon a long history of deprivation.

    If you look at Americans you would see that prior to WW2 we too had a much higher savings rate.After the war with American power and security enshrined and backed by an industrial base that produced 75% of the worlds GNP according to some accounts ,that changed. Generations felt "secure" and started to consume proportionately. It became a way of life. "More " was expected for each generation, especially during the Regan years. Fools Gold one might add.

    As America goes into imperialist/ economic decline reality catches up. Capitalist competitors take their share of world markets and a declining rate of profit, (remember Marx?), increases competition. The American working class is learning the hard way that they too will be forced to save - more and more just to survive. That too will be a cultural shift as a result of economic conditioning. In the old days at Berkeley my old alma mater, we called it "historical materialism".

  • Report this Comment On September 26, 2009, at 6:50 AM, BucketOfOnions wrote:

    Chinese stocks are hot. Taiwanese stocks are not. That's about to change.

    Taiwan will hold its presidential election on March 22nd. Barring an extraordinary electoral surprise, Ying-jeou Ma, the candidate from the pro-business and less China-averse KMT will win the election. (Currently Ying-jeou Ma is leading with 63% in Taiwan's political futures market.)

    The relationship between China and Taiwan is best seen as a broken marriage. China wants to reconcile the rift on its own terms, and threatens consequences if that should not happen. Taiwan, on the other hand, suffers from multiple personality disorder. One part of it wants an outright divorce. The other wants to stay separated with the option of eventual reconciliation.

    For the last eight years, Taiwan has been ruled by a president who favored outright divorce. His government has been responsible for hampering economic interactions between China and Taiwan. As the result, Taiwan's economy languished exactly when China was making a great leap forward. Taiwanese stock market is basically where it was eight years ago. But many emerging economies have seen their stock markets double or even triple during that time. It's likely we'll see a catch-up rally once the dust settles after the election.

    Even a surprise win by DPP candidate Frank Hsieh wouldn't be that bad for Taiwanese stocks. He's seen as a pragmatist within his party. Rhetorically, he would still want the divorce. Economically however, he wouldn't mind sleeping with China.

    ---------------------------------

    Money without intelligence is like a car without a road.

    http://www.intelligentinvestingtips.com

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