As the U.S. economy drags its heels toward a slow exit from recession, China is zipping along the path toward 2007-style economic growth. According to a recent report by the Institute of International Finance, China's GDP is set to grow by 7.5% this year, and a sizzling 9% in 2010.
The Shanghai Composite Index is up more than 50% this year, while Hong Kong's Hang Seng Index is in bull-market territory, having risen more than 20% from its starting point in January. Many big Chinese U.S.-listed shares and ADRs, such as Aluminum Corp. of China and Baidu
But as with all economic booms, Fools, just because there's growth, that doesn't mean you should buy everything in sight. Today I'll talk about three Chinese stocks you should avoid.
Change the oil
Few things get international investors more excited than China's insatiable demand for oil. The combination of black gold and Chinese consumption are admittedly a thrilling prospect. There's good reason for that, too.
The price of crude has more than doubled this year. In May, Chinese oil companies refined a record 31.2 million tons of crude, representing an impressive 10.7% increase from the same month last year.
You might think that's great news for hybrid refiner-producer PetroChina
For a start, despite its recent gains, China still only refines a tiny amount of crude itself compared to the rest of the world. But more importantly, PetroChina combines upstream operations as a producer with a major downstream component in its refined product sales. That leaves it vulnerable to price controls within China, which can limit its profits when crude oil prices rise.
It is possible to make the argument that PetroChina is somehow "hedged" versus dramatic oil-price moves as a result of its mixed business focus. But that argument loses its appeal somewhat when you look at the company's aging oil fields and high cost structure, according to JPMorgan. Moreover, for investors who want to hedge against oil-price fluctuations, you can just buy two stocks: one top oil producer and one top refiner.
The lack of business focus on PetroChina's part may help explain why, with 18% in gains this year, the company's stock price performance trails both upstream producer CNOOC and downstream refiner Sinopec Shanghai Petrochemical.
Not on your life
Investors in China also tend to turn a blind eye to bad operating practices in life insurance. Once again, with more than a billion people all slowly entering the workforce, creating an emergent "middle class," the thinking goes that it's only natural that some of them will start loading up on life insurance.
There's probably some truth to that. And if you are an investor in insurance companies, I can understand why homegrown brands such as MetLife
Still, don't take even a small bite out of this durian: it may be lethal to your long-term financial health. China Life Insurance has total assets of around 1.04 billion Chinese yuan ($152 million) on its balance sheet, offset by liabilities of 556.4 million yuan ($81.5 million). At first glance, that looks fine.
But that's only until you notice that long-term investments account for 461.5 million yuan ($67.6 million) of the assets -- and a lot of those long-term investments are in shares of Chinese-listed banks. In recent years, the government has tried to encourage insurers to use their massive cash reserves to provide funding to the financial sector. China Life Insurance has stakes in about 10 Chinese banks today, with a hefty 20% ownership stake in Guangdong Development Bank.
As you'd probably expect, China Life's equity investments performed poorly last year. A 4.7% loss ate substantially into the company's overall return on investment. With such a lack of transparency or predictability of income, it's really hard to see why anyone would pay 36 times earnings for the stock.
Talk of unpredictable earnings and high P/E ratios brings me to China Telecom
China Telecom posted good first-quarter results, reversing a big fourth-quarter loss and picking up an additional 4.93 million customers. Still, the telco's profit of 4.7 billion yuan ($688 million) is still well off its gain of 6.47 billion yuan in the same quarter last year.
Moreover, the P/E is only so high right now because of a huge one-off, fourth-quarter loss. China Telecom's forward-looking P/E is 18, which you might even call reasonable. But the Chinese telco industry is a volatile place that operates largely at the mercy of the whims of government officials. It's definitely not a place for risk-averse investors.
Keep your eyes open
The recent boom in China is much different from the bull run in 2006 and 2007, when these three companies saw triple-digit percentage gains. China's marketplace is more established than it was three years ago, and the world is no longer flush with cash in the way it once was. Hedge funds don't have the same capacity to use cheap Japanese debt in Hong Kong dollar-yen carry trades, and Chinese locals probably aren't "backpacking" their currency over the New Territories in order to get a piece of the action of Hong Kong's property bubble as they did in years past.
China may never have been sober, but it's not punch-drunk on its own growth anymore, either. Make sure you invest like it’s 2009, and stay away from companies that don't have a good chance of offering growth that you can reasonably predict.
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Fool contributor Daniel M. Harrison owns no stocks mentioned in this article. Baidu is a Motley Fool Rule Breakers recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.
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