Wednesday, August 29, 2007

How to invest in China

Please note that the topic of this post is not “What to buy in China” but “How to invest in China”. Many of the posts that I see on Seeking Alpha (China section) are about China ETFs. The ETFs seem to be of interest because they are a security which offers the buyer immediate “China exposure”. This is understandable. Any market that has tripled in 12 months as the Shanghai Stock Exchange A share index has is of course going to attract huge interest. Unfortunately, buying China ETFs is really not a very sensible way to invest in China. Yes, I know, I know, the ETFs have been tremendous performers (at least recently). But we can all think of securities which perform well for a period of time which are NOT necessarily smart investments (I seem to recall subprime backed CDOs were terrific performers for several years). The main reason not to buy the ETFs is that they are comprised almost entirely of SOEs (State Owned Enterprises). That is, the controlling shareholder is the Chinese government, i.e., the Communist Party of China. Now I am not going to make a moral or ideological argument that Communists are evil and can’t be trusted. The folks in China who call themselves Communists aren’t really communists anyway – and in fact I think the senior leaders of China have actually done a spectacular job at running China in the last quarter century. No, the reason not to buy an index composed of SOEs is the following:

1. They are managed first and foremost for the benefit of the state; employees are next and then come the interests of shareholders.

2. Senior executives, including the CEO, CFO, and board of directors are either directly appointed – or if not appointed than must be approved - by the party. Shareholders can have little confidence that management is highly qualified – or if management is qualified, that they will remain in their jobs.

3. The biggest SOEs are essentially in three sectors: telecoms, financials, and energy and other materials. Returns on investment for companies in the first two sectors, telecoms and financials, are primarily a function of government regulation. Returns in the energy and materials sectors are determined by government regulators and global supply and demand. In none of these industries is the underlying growth and productivity of China Inc primary return drivers.

4. SOE reform has been underway for decades but it takes many years and lots of hard work to turn a government bureaucracy into a profit maximizing competitive enterprise. There are some SOEs (like CNOOC) that have made great progress and are beginning to look, feel, and act a lot like a “real company”. But just as many if not more SOEs are still “Potemkin companies” (ah the irony). The banks are the best example. If anyone believes that the Bank of China is a profit-seeking enterprise run for the benefit of shareholders, this person needs to be put into restraints lest they lose all their money. Chinese banks were and continue to be, arms of the Chinese government which are operated at the local level by local government authorities. They make loans to whichever SOE they are told to and they charge the same rate on all corporate loans. The one thing these banks are really good at is creating non-performing loans – and we will see hundreds of billions more of these in due course.
Now I know someone will argue that they know a particular SOE that is well managed and has a good track record, etc. I’m not at all surprised. I heard a good pitch just today for China Life; it was very plausible and for all I know could very well be correct. My point is not that ALL SOEs are either of poor quality or who’s earnings are a function of regulatory allowance (or both), my point is that the majority of them are. Or, to put it another way, SOEs are structured to be bad investments. Why? The management and the controlling shareholder (the state) do not have as their primary objective the maximization of shareholder value. In a perverse way their interests are aligned. Unfortunately your interest is not aligned with theirs.

What we have seen in the last year or so as the market has zoomed higher and higher is mostly a liquidity-driven bubble. Retail investors, mutual funds, and corporates have all been playing the stock market like crazy (and btw, stock market gains make up as much as a fifth of all corporate profits). Will it continue? Who knows, but if I am going to invest in Chinese stocks in this kind of market, I certainly want to invest in one of the hundreds and hundreds of companies which are NOT controlled by the state, which are managed by performance driven CEOs (often the company founders) and which are not overtly affected by regulatory changes (because they are typically smaller so they make a less attractive target; and because they tend to operate in industries which are not of great national interest, e.g., shoe retailers or travel agents or advertising). Let me say it again to make sure I am not misunderstood: there are some SOEs which can be good investments and some private companies which are certainly bad investments. My point is that buying an ETF which is made up of 100% or almost 100% SOEs guarantees you will own a portfolio the majority of which is made up of companies run NOT for the benefit of shareholders by managements of dubious skill.

Let’s look more closely at the iShares FTSE/Xinhua China 25 Index (FXI). The average market cap is $70 billion so this is a mega-cap index with zero exposure to SMEs. Second, if you look at sector weights, you can see that financials make up more than 40%, energy and materials about 30%, with telecoms at about 20%. The reason to invest in China is GROWTH but this is not a growth portfolio!

So what to buy instead of ETFs? How about a mutual fund? Not sexy enough for you? You don’t like them because they don’t allow you to jump in and out of the market each week or so with your superior market timing skills? Don’t kid yourself. China is a great – a once in a lifetime – opportunity but it is a long term play and neither you nor I nor even the most savvy experienced Chinese fund manager has the SLIGHTEST CLUE when the market is going up or down. If ever there was a buy and hold market, this is it.

Why are some of the mutual funds (and perhaps one or two actively managed closed-end funds) superior? Because some of the them hold most or the majority of their assets in small and mid-cap PRIVATE COMPANIES. I don’t mean private in the western sense of not listed, I mean private in the Chinese sense of not being owned or controlled by the state. It may come as a surprise to those who are less familiar with the current Chinese corporate environment but the single most astounding and impressive fact about China is the existence of THOUSANDS of private SME companies – the majority of which are well established and profitable and growing at 20+% per year. Why buy a highly regulated phone company or bank run by a party hack when you can buy an entrepreneur founded private company operating below Beijing’s regulatory radar screen in manufacturing or services? This is THE opportunity in China and it is available to anyone who cares to logon to Morningstar and has a Schwab account.

The clincher in the argument as to the superiority of actively managed open or closed end China funds is that you can get the “great” in “greater china”. As many of you surely know, China is three markets (at least):
- PRC A-shares: Shanghai and Shenzhen exchanges
- Hong Kong H-shares
- Taiwan companies
But for all intents and purposes, these are all China stocks and any China investor should select among all of them. FXI has zero holdings in Taiwan. Some of the mutual funds invest among all three markets.

I will post next week on which of the available China mutual and closed-end funds look most attractive. According to my first screen, there are 12 mutual funds and 1 closed-end fund with more than $100 million in assets that invest in China. Several of them have outperformed FXI (not that that should be the primary determinant). China is going to be an important and attractive investment opportunity for a great many years to come. Hence there’s no reason to rush in and buy a portfolio of poor quality (and expensive I might add) stocks just so that you don’t miss tomorrows 2% spike. Take a bit of time and invest in a good fund. You probably won’t triple your money in the next 12 months but you probably WILL triple you money over the next five years. It’s called investing.


Anonymous said...

Anonymous said...

I read this first when you posted on Seeking Alpha and have been eagerly awaiting your follow-up and the list of funds. Please do post it soon - this was a very thoughtful and intriguing article!