Why Chinese Equities Might Scare You

Chinese equities have been on a tear. Even with the pullback of the past couple of months, Chinese stocks are up more than 100% for the year and up nearly six-fold over the past two or so years.

Over the next five or 10 years, Chinese companies will probably be worth even more than they are today. But anytime a stock market rises so rapidly, it's best to heed Warren Buffett's simple advice that it is a very good idea to avoid stocks that have risen dramatically in a short period of time.

Do as I say and as I do
Buffett has always methodically followed his own advice and he is no different with China. A few months back, Buffett's holding company, Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B) gradually sold its entire stake in Chinese oil company PetroChina (NYSE: PTR). Apparently, Buffett felt his investment had reached fair value and he took advantage of selling in a rising market. Berkshire's roughly $500 million investment was cashed out for around $3 billion.

In addition to PetroChina, companies like Aluminum Corporation of China (NYSE: ACH), one of the world's largest aluminum producers, and China Mobile (NYSE: CHL), which offers cellular service in China, will -- in my opinion -- surely continue to grow.

As the emerging economy grows, the need for aluminum and other metals will increase. Similarly, more Chinese reaching the ranks of the middle class, along with more affordable service, should bode well for China Mobile. Unfortunately, the current valuation in China leaves no margin of safety. A percent or penny short of expectations could cause investors pain.

Addicted to equities
China's stock price surge is due largely to increased participation by local traders and investors looking to cash in quick on the boom. Adding fuel to the fire, the Chinese government tends to hold controlling interests in the biggest companies. With very little stock available to meet local investors' surging demand, prices can leap quickly. And lately, Chinese companies have become infatuated with each other, which could be the spark that causes everything to blow.

Chinese companies, both big and small, have become major players in the stock market, and some are doing so with reckless abandon. While exact figures are hard to pin down, some analysts suspect that nearly a third of reported corporate earnings in China come from investments outside the companies' principal lines of business. In other words, earnings are being fueled by the earnings of other Chinese companies, via investment in shares of stock.

How painful could it get?
The situation becomes frightening when you consider what would happen if share prices started heading south. Chinese companies that own portfolios of Chinese stocks would have to report portfolio losses on income statements, further depressing earnings. That, in turn, would hurt those companies' stock prices, which could send the market down further at a very fast pace. Investors who don't exercise caution would incur substantial losses.

To realize how ugly things could get when companies rely on investment earnings to fuel their own earnings, consider the Youngor Group, a private Chinese garment maker with around $800 million in sales. Founded in 1979, Youngor has become one of China's top-selling apparel brands. Recently, Youngor's apparel operations have paled in comparison with its stock portfolio. The company holds stakes in China Life (NYSE: LFC) and Citic Securities, both red-hot stocks. The gains on Youngor's stock portfolio helped the company book some $223 million in investment income in the first nine months of the year, equaling a stunning 98.5% of overall earnings.

While this particular situation stands out as an extreme example, it nonetheless reveals another layer of real risk to which investors should pay serious attention. Consider that the Shanghai index is down more than 700 points, or more than 10%, from the all-time high it reached on Oct. 16. Investors, as stewards of capital, must tread very carefully in overly optimistic markets.

For further related Foolishness:

• An Ultimate Buying Opportunity?
• The Art of Selling High