The Motley Fool Global Gains team is headed to China in July for research. Ahead of that trip, they're taking time to discuss some of the issues facing China, and investors in China, today.
There's no shortage of Chinese companies that have been accused at some point in their history as public companies as misrepresenting themselves, their business, or their financials. And even in the large-cap space, you recently had China Mobile announce a puzzling $6 billion acquisition of Shanghai Pudong Development Bank. So, can you trust Chinese companies to be good stewards of your investment dollars, and if not, why should one bother investing in the sector?
Tim Hanson: My perspective is simple: China's reward profile makes it worth investing there, but it's risk profile makes it necessary to be careful. This is particularly true in the small-cap space, where frequent capital raises, serial and dubious acquisitions, and a cast of shady characters make trying to pick the winners seem even more difficult than navigating a minefield.
I continue to steer clear of Skystar Biopharmaceutical (Nasdaq: SKBI ) , for example, because I legitimately cannot estimate what its share count might be in a year, even though I like the business.
Further, it's worth recognizing that there are cultural differences. Take American Oriental Bioengineering (NYSE: AOB ) , for example. That company came under fire for a purchase of a new corporate headquarters in Beijing that by almost any isolated analysis looks like they overpaid for. The wink-wink-nod-nod story that floated, though, was that a heightened presence in Beijing would help them secure tax breaks and benefit from China's new government health-care plan. Given AOB's recent financial results, it's clear neither of these benefits materialized, but given how important guanxi, or relationships, are in China, it's not outlandish to think that they could.
Then there are the instances of restatements, material weaknesses, and allegations of financial shenanigans that have hit FUQI International (Nasdaq: FUQI ) , China Sky One Medical (Nasdaq: CSKI ) , and most recently, China Marine Food (AMEX: CMFO ) , among others.
With all of them, one has to consider the sometimes compelling evidence of impropriety with the reality that these are immature public companies that likely kept several sets of books in China in order to avoid taxes.
Given these "issues," many American investors just avoid China altogether. That's short-sighted. China's economy will be the largest in the world in 20 years. That said, the risks in China are real, so look for companies with reputable auditors, and buy your small-cap China exposure in a broadly diversified basket, with no company representing more than 1% or 2% of your overall portfolio.
Nate Parmelee: Potential aside, China is still considered a market where foreigners won't get a fair shake, and there are plenty of companies out there that back up skepticism of the market. As Tim mentioned, accounting concerns and questionable transactions can absolutely kill shareholder returns.
All hope is not lost though. Every time we visit China, we meet a management team that shows they understand the concepts of cost of capital and return on invested capital. While that's often because that same management team has made capital raising mistake or two in the past, the growing awareness of what is means to be a shareholder-friendly company is reassuring.
As long as I continue to see examples of companies grasping this crucial concept, I think there is a chance for trust to improve.
Sean Sun: Like everything else with China, investing there is all about the subtleties. Viewpoints on both extremes ("China is the promised land!" and "China is entirely fraudulent!") miss the truth that lies in the middle. That said, while it's always safe to be asking, "How am I being screwed here?" the fact is that even when it looks bad with some Chinese companies, there may not actually be malevolence on the other side. Better bets are incompetence, ignorance, and negligence. (Are you reassured yet?)
From an analyst's perspective, the biggest wrench is valuing Chinese equities with any degree of accuracy. That's why I think it's important to look at China with an expected value framework, where you're not looking simply at the outcomes but also the probability of those outcomes actually occurring.
Since our estimates of probability are almost certainly going to be wrong, it's important to have a decent risk-reward profile to make any individual investment make sense. When I look at New Oriental Education (NYSE: EDU ) , for instance, I think there's essentially a 50-50 chance that my thesis is right. If I'm wrong, EDU drops 50% in value. If I'm right, New Oriental Education remains the dominant player in a huge (and relatively untapped) Chinese education market, and the stock goes to the moon.
Think about it this way: If someone offers you a coin flip where heads means you lose $0.50, and tails means you win $5.00, you take that bet any day, every day (so long as you don't risk so much that you can't stay to play again). China is one of the few places in the world today where that bet exists.
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