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The Worst China Mistake You Can Make

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It's undoubtedly painful to have been an investor in any of the Chinese-listed companies that have been alleged to be or exposed as frauds over the past year. That's a feeling that's been shared by individual investors as well as by revered professionals such as John Paulson (Sino-Forest), Hank Greenberg (China MediaExpress), and Lee Ainslie (Longtop Financial).

We've shared in that pain at Motley Fool Global Gains as well, with two of our China picks, Yongye International (Nasdaq: YONG  ) and China Green Agriculture (NYSE: CGA  ) , having had serious questions raised about them at one time or another. We believe our research of these companies has addressed these questions, but it is also true that our once-significant gains in these stocks have been largely erased.

A better way?
It's in the face of those losses that many Fools have asked me why we bother investing in individual Chinese companies at all. Even if China's economy continues to grow, wouldn't it be easier and safer just to buy an exchange-traded fund such as the China 25 Index (NYSE: FXI  ) and remove some of the company-specific risks that have recently crushed so many investors?

In theory, this approach makes sense. Spreading one's China-targeted investment dollars across enough companies so that no single blow-up can derail the entire investment approach should enable an investor to make money from China's growth (and some of the promising valuations available today) without having to fear that someone somewhere is lying about their books. In fact, we've tried to embrace this approach at Global Gains by advising Foolish investors to own no less than a handful of Chinese companies, all in small positions, and to pair those Chinese positions with multinationals such as YUM! Brands (NYSE: YUM  ) and Coca-Cola (NYSE: KO  ) that are succeeding in China, seeing outsized growth as a result of their presences in China, and even pursuing their own acquisitions of domestic Chinese companies.

The objection is that finding handfuls of promising companies takes time, that tracking a broad basket is no small feat, and that the basket approach results in higher-than-necessary transaction costs. So really, why not just go with the ETF?

The big problem with that
Put simply, the popular, market-cap weighted ETFs are a dangerous way to invest in China. The reason is that the Chinese government manipulates its stock market, using rulings and regulations to promote giant state-owned enterprises and generally restrict smaller, more entrepreneurial companies. One consequence of this approach is that China's largest listed companies are generally state-owned and rarely run in the interest of outside foreign shareholders.

At the top of the list are China's banks, which have been making loans hand over fist in the past few years to both other SOEs and municipal governments to support China's GDP growth seemingly without concern for whether they will ever be paid back. In fact, China's national auditor revealed in late June that municipal debt in China had reached $1.7 trillion and that the ability of local governments to pay back their debts was "quite weak." Of course, as we learned here in the U.S. during our own mortgage crisis, someone has to fall on the sword when debts don't get paid back. By keeping a wide spread between interest and deposit rates in China, the government is already asking its citizens to subsidize its banking sector. Given that fact, it's unlikely foreign shareholders will be protected at all in the event of a widespread Chinese banking crisis.

And what happens if you invest in FXI for your China exposure? Well, you get nearly 50% exposure to China's financial sector. Provided you're invested in baskets of Chinese and multinational companies for your China exposure, you'll likely be better off in the long run with a 1% or 2% position in a company that turns out to be a complete fraud than 50% exposure to China's troubled and shareholder-unfriendly banking sector.

If that weren't bad enough
Furthermore, although China's banks are enormous financial institutions and easily verified to exist, recent events have shown that like some of their small-cap peers, they're not 100% reliable in the honesty department either. Several large auditing firms, for example, have noted in resignation letters that some of China's biggest banks have lied when asked to confirm company cash balances.

Put together an industry governed by perverse operating incentives with a growing track record for dishonesty, and it's clear that banks are China's biggest risk.

The global view
Hiking in Maine on vacation last week, I asked one of my companions after we'd reached the top of a mountain if we should go back down the way we came or go down the other side. His answer is that he preferred to go the way that was easier and safer. It was a logical answer; these two traits generally play well together.

When it comes to investing in China, however, the easier way is looking more and more like the most dangerous way -- which is why the worst China mistake you can make is choosing to invest in the country's growth via a popular ETF.

Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Yongye International. The Motley Fool owns shares of China Green, Yongye, Coca-Cola, and YUM! Brands. Motley Fool newsletter services have recommended buying shares of China Green, Yongye, and Coca-Cola. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Read/Post Comments (11) | Recommend This Article (15)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 14, 2011, at 2:44 PM, Medicalrecordman wrote:

    People should start looking to notorious short-sellers for clues as to whom will emerge unscathed. Why ? Because their on-the-ground DD teams are not only finding all the frauds, but they're now also disclosing the Chinese stocks they're buying. Take notorious short-seller GeoInvesting for example. Yesterday their team issued an alert that they were buying VALV. Did you see what the stock did ? Wow !! This morning they just put out an alert that they're now buying OSN and will put out a detailed report shortly. With EPS estimates calling for .94, OSN is obviously wayyyy undervalued and under the radar. I'll bet it pops hard just like VALV did.

  • Report this Comment On July 14, 2011, at 5:31 PM, CMFStan8331 wrote:

    When you have no idea whether you can trust the numbers a company gives out, investing becomes the equivalent of casino gambling (where the house always wins if you keep on playing long enough). When you consider the dual problems of the Chinese government meddling in the markets and the lack of adequate governance of Chinese companies, it's pretty hard for me to make a good case for investing there at this point in time. Some folks will undoubtedly still hit jackpots with Chinese companies, but that doesn't imply that it's a smart move to accept the inherent risks.

    Thankfully I've been cautious about investing real world dollars in individual Chinese stocks or China-specific ETF's. I've trimmed what little I did hold back to a single company (FMCN) and may go ahead and liquidate it soon. Unfortunately, I was somewhat less judicious with my CAPS picks. :-)

  • Report this Comment On July 15, 2011, at 1:46 AM, TMFAleph1 wrote:

    <<you'll likely be better off in the long run with a 1% or 2% position in a company that turns out to be a complete fraud than 50% exposure to China's troubled and shareholder-unfriendly banking sector.>>

    Unless I'm mistaken, this comparison doesn't work. I assume when you refer to 1% or 2% position, that is a percentage of your entire portfolio. Meanwhile, the 50% represents the exposure relative to your ETF position only. As such, unless you assume that one invests one's entire portfolio in the FXI ETF, these numbers aren't directly comparable.

    Alex Dumortier

  • Report this Comment On July 15, 2011, at 10:54 AM, TMFMmbop wrote:

    Hi, Alex.

    Sorry this is unclear. It's assuming a broader, say 10% to 15% exposure, to China writ large, with the choice being between putting all of that exposure in FXI or buying 10 to 15 individual, non-financial Chinese or China-related stocks.


  • Report this Comment On July 15, 2011, at 1:12 PM, TMFAleph1 wrote:

    Thanks for the clarification.

  • Report this Comment On July 16, 2011, at 12:26 PM, echapman47 wrote:

    I was planning to sell my exposure to FXI anyway. What is the concensus on STV ( Chinese digital TV) ? I purchased it at $6.39 I believe but the stock price has gradually declined. Just wondering.

  • Report this Comment On July 19, 2011, at 10:49 AM, expatinchina wrote:

    The Worst China Mistake You Can Make: allowing the object of your due diligence to provide the Chinese to English translation that guides your investment decisions.

  • Report this Comment On July 19, 2011, at 4:35 PM, susan400 wrote:

    Quite frankly, AFTER the losses, its

    well coulda dne a index fund!~

    FACT emertging countries have ETHICS risk,

    if you can't judge it. stay out of the kitchen.

    It is very hard to overcome 75% losses.

    Avoid advisors that kame it sound c o o l and


    #39 for TMF

  • Report this Comment On July 23, 2011, at 5:19 AM, ccisland wrote:

    Agree wholeheartedly with author on ETFs. In general state-owned stocks are difficult to value given all the meddling by government, so why should you own them? The weight of banks in the index is worrying. China's credit to GDP ratio is easily the highest amongst emerging markets, and as we all know when credit bubbles burst/deflate, banks get hit hardest. Having 50% in Chinese banks today looks unsound (despite being apparently 'cheap' vs index). On the other hand several of the US listed chinese stocks are looking good. The negative sentiment over last 12 months or so has just pushed their shares down but not changed the businesses. Would not be surprised to see further management buyouts like Harbin (HRBN), large share purchases by management e.g. (YONG) and PIPE investments by private equity firms (again Yong, HRBN) given listed share prices are cheap compared to onshore PE deals where there's lots of money chasing the opportunities. (I own both HRBN and YONG)

  • Report this Comment On August 14, 2011, at 2:00 PM, goldminingXpert wrote:

    You ever going to give up on this failed trade? Get out of CGA and YONG while the getting is still fairly good.

  • Report this Comment On August 14, 2011, at 2:25 PM, soycapital wrote:

    "You ever going to give up on this failed trade? Get out of CGA and YONG while the getting is still fairly good."

    Good advice, take it, these companies don't qualify as investments.

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