As co-advisor of Motley Fool Global Gains and someone who spends a lot of time studying small Chinese stocks, I've been accused in the past of being a bit too optimistic when it comes to China. After all, I've said:
- There are cheap stocks in China.
- I'll make money in China.
- China's stimulus plan will change the world.
Yet in a rare moment of self-reflection (I kid), I realized there's one definite reason why I present such a bullish case for Chinese investments here week after week. I'm reacting against the naysayers, in our own Fool community and elsewhere, who believe they're better served by ignoring -- or even shorting -- China. While I clearly think that's a terrible idea, I do have a few deep reservations about China's economy and future that I thought I'd share in this week's column.
The elephant in the room
Let's face it: China is run by a totalitarian government that's somehow managed to maintain control of its country while hybridizing communism and capitalism. It's a feat of genius in many ways, but I seriously doubt it can last.
When and how will the inevitable transfer of power occur? Rather that dig into this question's political implications, I'll focus on its potential effects on investment. Remember that most stock valuations are based on some projection of future cash flows -- usually at least 10 years into the future. Will China's government be around in 10 years? If not, how will that affect the openness of the Chinese economy to foreign investment and the role of state-owned companies such as PetroChina
Furthermore, will currently protected industries and favored companies within China suddenly be dominated by cash-rich multinationals such as General Electric
On the other hand, if the government is still around in its current form, will it have cracked down severely on capitalism, decimating investors in the process? Frankly, it's very difficult to know.
A banking sector blow-up?
If you listened to Chinese premier Wen Jiabao's comments at the World Economic Forum in Davos, Switzerland last week, you know that he blames the United States for the current economic downturn, particularly the "excessive expansion of financial institutions in blind pursuit of profit."
While I'm no fan of excessive expansion in the blind pursuit of profit, it seems short-sighted to me to imply that the Chinese banking industry is a global model for best practices. After all, it's entirely state-run and is reputed for handing out loans at discount rates to well-connected government officials. Given the Chinese government's massive foreign reserves and propensity for covering up embarrassing failures, we may never know just how many bad loans pollute the Chinese financial system today.
In addition, by historically discriminating against small business and unconnected individuals in making loans, China's state-run banks have effectively increased the cost of capital in the country, helping to widen a wealth gap that is now contributing to significant discontent. Unrest among the citizenry has clear implications.
Higher capital costs have also forced companies that can't access lower-cost bank financing to pursue excessive expansion, in the blind pursuit of covering their cost of capital and growing large enough to qualify for bank loans. That, in turn, has led to uneven economic development in China, with a reliance on low-cost manufacturing and a concentration of economic activity on the coasts. It's also spurred an environmental disaster that threatens the country's air, water, and food supplies.
At some point, China's banking sector needs to liberalize. From an investing standpoint, that could also flip the competitive landscape in some industries on its head, and reveal currently hidden warts in the financial space.
Allow myself to introduce ... myself
Finally, and perhaps this is a smaller concern than the others, I'm concerned that some Chinese companies are too promoting -- trying to cash in via the capital markets rather than build sustainable companies for the long term.
Even if that's not the case, Chinese companies are relatively unsophisticated in how they deal with the stock market, and especially with Western investors. Many Chinese companies -- when listing publicly -- forego the names they operate under in China, instead advertising themselves instead as China Something Something. The Something Something usually includes hot buzzwords like water, solar, technology, green, awesomeness, utopian solution, etc. These companies are also generally sticklers for quarterly guidance (why bother?), trumpet earnings numbers that have been inflated by irrelevant currency gains (we're just going to back those out), and often focus on GAAP earnings (pointless) at the expense of more relevant cash earnings and cash conversion cycles.
Ultimately, companies get the shareholders they deserve. If they focus on short-term factors, they'll get a host of short-term shareholders. I think that may explain why Chinese stocks listed on U.S. exchanges have been hit particularly hard during this recent downturn. If Chinese companies aren't out to defraud investors (and I don't think they are; indeed, some of our top picks in China are guilty of one or two of these practices), they should change their ways.
The good news is that those changes should be easy and painless, though my other two concerns will likely remain major question marks for some time. But that's why, at Global Gains, we research our China recommendations carefully, and we only buy with a significant margin of safety.
After all, while I've said before that there's a fortune to be made in China, I'll emphasize now that you'll only make it if you're very, very careful.
Tim does not own shares of any company mentioned. Huaneng Power and Google are Motley Fool Rule Breakers recommendations. Huaneng Power is also a Motley Fool Income Investor pick. Apple is a Stock Advisor pick. The Fool's disclosure policy spits at changing its ways.