So You Want to Invest in China: A Short Primer on the Unusual Risks

For this episode of Motley Fool Answers, Robert Brokamp and Alison Southwick wanted to consider one of the biggest macroeconomic dangers facing Americans today: the full-blown trade war President Trump seems determined to heat up with China. To help, they brought in an outside expert: Scott Kennedy, the director of the Project on Chinese Business and Political Economy for the Center for Strategic and International Studies -- a nonpartisan, foreign-policy think tank.

But in this segment, they ask Kennedy to talk specifically about investing in Chinese companies. In some ways, he's highly enthusiastic about what businesses are doing there. Nonetheless, he advises extra caution, regardless of how the current conflict plays out -- and he has some compelling reasons why.

A full transcript follows the video.

This video was recorded on April 24, 2018.

Alison Southwick: I also want to talk a little bit about investing in Chinese companies, because here at The Motley Fool we have a few recommendations that we've made to our members that are Chinese companies. Baidu, Tencent, and JD.com are just a few of them. But Chinese companies don't necessarily have the best reputation for honesty or transparency. Misrepresentation and outright fraud is a risk to some extent when you're investing in China. I'd like you to speak to that a little bit. How concerned should our members be when they are looking at investing specifically in Chinese companies outside of the context of a trade war or within the context of a potential trade war?

Scott Kennedy: I think you want to be very careful, particularly if there's an opportunity for you to invest in Chinese companies that are listed in China or in Hong Kong. The corporate governance rules and regulations for China's domestic exchanges are a lot weaker. It's not a casino. A casino would be fairer. At a casino you know the rules and they don't change while you're at the table.

In China, the rules for investing change depending on the day, and the levels and anxieties of investors and regulators in companies, and what's in the news. It's really dangerous to invest directly in China. Luckily, there's lots of obstacles to doing that because China primarily allows foreigners through large institutions to invest.

There are some other ways around that for your very savvy investors, but for the most part, the way you're going to invest directly in Chinese companies are going to be perhaps in Hong Kong, but most likely companies that are listed on NASDAQ or the New York Stock Exchange.

I think the corporate governance requirements [or] transparency requirements of our markets aren't perfect. They didn't stop what happened in 2008 to even your best companies. Nevertheless, it gives you a little bit more information and outright fraud and deception is more likely to emerge through Chinese companies that are listed outside of China. That's a general rule.

Because China is growing so fast and in so many different sectors, there's obviously lots of huge opportunities. Companies are profitable. They have long-term chances of success, so it's a smart thing to pay attention to, but there are other ways in which you can invest in, like ETFs, or mutual funds, or American companies that are deeply exposed to China like Qualcomm. Over half of the sales for this company are in China. So, there's other ways, if you're worried about whether a Chinese company's profit and loss statement is accurate, to still be exposed to China, but reducing your risk against any individual Chinese company.

Southwick: If I am thinking about whether I invest in Google or Baidu, should I be able to trust the financials that Baidu is putting out as much as I should be able to trust what Google is putting out?

Kennedy: Well, they both use the same accounting firms...

Southwick: You're like, "Sure. There are crooked people everywhere."

Kennedy: And I don't want to just pick on Baidu.

Southwick: I did for no particular reason, here.

Kennedy: I'll just give you an example of a new company that people might want to pay attention to [not because I necessarily think it's going to be super successful, or profitable, or that the stock's going up]. I never give stock advice.

Southwick: No, we're not asking you to.

Kennedy: That's really bad. Just ask my mom. I stopped doing that about 25 years ago. Knowing something about China doesn't mean you know anything about how to invest in Chinese companies. Just as an example, China's got the fastest-growing electric car market. Now, there's never been an electric car company on the face of the world that's been profitable from selling electric cars. They might sell other stuff that helps the company be profitable overall, but usually the electric car business isn't profitable.

Components for electric cars can be quite profitable, including the battery. Right now, the biggest, most successful, advanced electric battery companies are Panasonic, LG Chem, and Samsung. There's others in the supply chain that are doing well, and even some American companies, but those are the biggest sellers right now in Asia.

But China's blocked its market to foreign car battery makers and has been promoting domestic ones. People have heard of BYD, the company that Warren Buffett invested in a long time ago, which is profitable largely for things other than electric cars. They also make batteries and many other things -- buses and stuff -- that they sell in the United States.

There's another company that has come on the scene called CATL. It's in Fujian Province. It's in a town called Ningde. And CATL originally was a joint venture with a Japanese company called TDK. Everyone knows TDK because you have the cassettes that were made by TDK. But they also were a chemical company and did other things and helped CATL get off the ground. They make pretty good car batteries, now, and they don't have that foreign competition to face. China's pushing electric cars as hard as anybody. This is currently a non-listed company that is exploring listing.

And if you don't have any foreign competitors, and you make a pretty good battery, and just by coincidence, Xi Jinping's first job as a party secretary was as the party secretary of the County of Ningde where this company is from; is there a coincidence? It could be a coincidence. I honestly can't say for sure. Nevertheless, the stars are aligning for this company. Again, that depends on Chinese industrial policy, it depends on the corporate governance of this company, and many other things that could take it in one direction or another.

But there's so many different companies like that in China, whether you're talking in e-commerce, or in healthcare, and drug manufacturing, and elsewhere. Things that look like they're super rising stars and then suddenly they go in a different direction. That's why China is exciting, but it also means folks need to be careful, too.

Southwick: Let's end on a super, happy, positive note, because trade war isn't super, happy, and positive. What would you say is one of the best stories you've heard coming out of China, lately, that people should keep an eye on? Something we can get excited about in a positive way?

Kennedy: I think CATL is a really interesting company that excites me to look at and learn about, and I have no idea what its commercial performance will be down the road. I've met so many different companies in the internet space. China's got 700-800 million internet users. Entrepreneurship there is so cool. I can't write code, but just about everybody else can and you don't need a lot of money to create an app. And when you've got anything times 700 million [users], that's a lot of money.

WeChat, the communication app which is by Tencent, has so many other things. I think that's pretty cool and I think Tencent is a really interesting company. But there's so many small, garage-like companies in the internet space. Many of them will disappear, as they should, through creative destruction. I just love meeting these investors and what they're doing.

Let me give you one example of a really neat technology. I have no idea what it's going to mean for this specific company I met that's developing it. But I went to the Microsoft Incubator facility in Beijing, and they support this one company that makes a piece of equipment that you put in the soil, or up against the plant, and it tells you the moisture of the plant and the soil. But it also can tell you what's going on in terms of the nutrients in the soil, pesticides, and other things. That's cool.

But cooler, and why they're cooperating with Microsoft, is because you take that technology and you connect wireless equipment to it that can transmit the data up to a satellite and down to the cloud. Now, if you're the farmer, then through your phone you can see what's going on, on your farm.

Now, let's say you're the county party secretary, and you want to know what the yield is going to be for soybeans in your county. Now you have a better sense of where things are going to go because you know the weather and you know what's going on. You know how it's affecting the crops. Let's say you're the head of the province or you're the head of the country and you want to know what the wheat yield is going to be for this year. You've got more information.

Now, let's say you're sitting in your apartment in Little Rock, Arkansas and you invest in commodities. China's a big commodity producer and you now have a lot more information and it's going to tell you what's going to happen with futures.

That's a really cool technology that's being worked on by this company that I met that's in the Microsoft Incubator. I have no idea how long it's going to take for it to really have all the different technologies connect, but those are the type of really cool things that even in China folks are working on. Even though you have all that top state-down stuff, which is depressing, you have all this bottom-up stuff at the same time where you can get excited by what people are really doing.

And that's the benefit of China. It's such a big place. You've got all these crazy stories and deep concerns about the state, but there's also lots of really cool, smart-thinking people.