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.