China Inc. is Out on a Limb
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Transcript of China Inc. is Out on a Limb
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062
china inc.is out on
a limb
BUSineSSWeeK I NOVEM BER 26, 2007
8/8/2019 China Inc. is Out on a Limb
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063
in depth
y now every investor on the planet is trying to handicap
what happens when China’s scorching-hot stock markets
nally start to cool o. The conventional wisdom is that
hina’s greenhorn individual investors will take the hit,
while corporate China—the companies that make shirts,
uild ships, and run utilities—won’t eel much at all. The
eal economy these companies operate in is ar too strong
o be aected by stock wobbles, goes the argument. The
rice o corporate shares may all, but underlying
arnings will power on.
NOVEM BER 26, 2007 I BUSineSSWeeK
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Ca’s socks ar sky-g. A Cs comas ar
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backsl a balac ss go o fr fall
That line o argument, though, is looking sus-
pect, or the simple reason that companies big and
small are now playing the markets with abandon,
using corporate unds to invest in each other’s initial
public oerings and bolster their bottom lines. Although
gures are hard to pin down, Morgan Stanley gures a third
o reported corporate earnings in China stem rom invest-
ments outside companies’ core businesses—which in al-
most all cases means plowing money into stocks. “It’s quite
dangerous or these Chinese companies because these gains
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by 163 companies a year earlier. Morgan
Stanley gures “noncore” earnings rom
stock, real estate, and other ventures ac-
counted or 54.1% o prots in China’s
health-care sector and 64.6% in the con-
sumer goods sector.
In China, ew investors possess the ability to comb through
nancial statements and distinguish a company’s operating
earnings rom its stock plays. “People overestimate Chinese
investors’ sophistication,” says Jerry Lou, head o China
research at Morgan Stanley. “Somebody needs to point out
that the emperor has no clothes.”
Proessor Ding cites the case o Black Peony, a textile com-
pany, as an example o what happens in a hot market. In the
rst hal o this year, Black Peony
recorded proits o $5.8 million,
almost all o it rom gains in shares
like Air China, dividends rom
other stocks and payouts rom a-
liates. Meanwhile, its core textile
business is struggling. “They’re not
controlling any costs because lie is
easy,” says Ding. Wang Panda, vice-
chairman o Black Peony, admits
his business did not do well. But he
deends his investments, saying he
has put much more money into a-
liates than the stock market. “We
have diversied,” he says.
Until recently banks lent reely at low rates to bankroll com-
panies’ investment portolios. Now regulators are trying to
stem the lending by increasing bank reserve requirements. But
those tempting IPOs keep coming, and corporate investors are
still lining up. No one inside China Inc., it seems, wants to think
about what happens when the bubble bursts. ^
have no cash basis,” says Ding Yuan, a
proessor o accounting at China Eu-
rope International Business School
in Shanghai. “It’s really rightening.”
Scarier still is what could hap-
pen i the stock markets head south.
Shanghai is more than 700 points o
its all-time high o 6,124, reachedon Oct. 16, though as o Nov. 14 it
was still up 102% or the year. I and
when stock prices start to all in ear-
nest, companies will have to report
these portolio losses on their in-
come statements, depressing their
earnings. That, in turn, could hurt
their own stock prices, pushing the
market down both urther and ast-
er. “It’s a replay o what happened
in Japan during their bubble,” says
David Webb, a Hong Kong-based
corporate governance expert andnon-executive director o Hong
Kong Exchanges & Clearing. Japan
Inc. gorged on stock and real estate, only to tumble into the
red when those markets collapsed.
To see how big an impact investment income can have
on earnings, consider the Youngor Group, which has some
$800 million in annual sales. Since the garment maker was
ounded in 1979, Ningbo-based Youngor has grown into one
o the country’s top-selling apparel brands. But these days
those operations pale in signicance beside its stock port-
olio. Youngor’s holdings include shares in China Lie, Bank
o Ningbo, and Citic Securities, the country’s largest broker
and a red-hot stock in its own right. Gains on these shares
helped Youngor book $223.6 million in investment income
or the rst nine months o the year, accounting or 98.5% o
overall earnings.
hooked on equities
Is Youngor concerned about its de-
pendence on Citic shares and other
equities? A member o Youngor’s
investment department, who re-
quested anonymity, downplays the
investments as “just a supplement.”
The company continues to load up on
shares, though. Hoping or a repeat
o its hit with Citic, Youngor has even
applied to regulators to participate in
a secondary oering o Haitong Se-
curities, whose shares have rocketed
885% since its rst IPO.
By increasing the number o available shares, IPOs like
Haitong’s have amplied the role that stock investments now
play in companies’ income statements. Wind Ino o Shang-
hai, which provides inancial data on listed companies in
China, estimates that as o June 30, 494 listed companies had
stock market holdings worth $45.6 billion, vs. $2.3 billion held ( t o p ) e v e n s l e e / c o l o r c h i n a p h o t o
064
in depth
BUSineSSWeeK I NOVEM BER 26, 2007
Data: Bloomberg Financial Markets
CSI 300 INDEX
6,000
5,000
4,000
3,000
2,000
1,000
0
CHINESE STOCKS’
RAPID CLIMB
JAN. 6, '06 JAN. 5, '07 NOV. 14
A vsor
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ccks ou sock
rcs a a local
brokrag
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a l e x n a b a u m
066
in depth
BUSineSSWeeK I NOVEM BER 26, 2007
By Aaro prssma
I you’re worried about investments
in China, you’re in good company.
Last month, Warren E. Buett liqui-
dated the last o his stake in oil giant
PetroChina, just weeks beore the
company staged a spectacular share
oering on the Shanghai exchange.
“We never buy stocks when we see
prices soaring,” the Oracle o Omaha
told reporters on a trip to China at the
end o October.
Chinese stocks have certainly
soared. The benchmark CSI index is
up more than 152% year to date. And a
food o Chinese companies have gone
public as ADRs, or shares on U.S. ex-
changes, with six that have more than
doubled in price over the past year.
So how do you play the white-
hot China market without getting
burned? Here are some ways.
Chinese stocks may be overvalued,
but many analysts think the country’s
economy will continue to clock
double-digit growth or years. That’s
why Mark Coelt, manager o the
Empiric Core Equity Fund, advises
clients to “go with the companies that
sell to China.” He avors Korean steel
producer Posco and mining giant
BHP Billiton, both o which benet
rom China’s demand or industrial
materials.
There are even ways or investors to
prot rom the quality issues plagu-
ing some Chinese exports. European
companies such as Bureau Veritas,
InterTek Group, and SGS see higher
revenues rom increasing demand
or testing o Chinese exports, says
Barry P. Dargan, manager o the MFS
International Growth Fund. “They’re
growing very well, and there are going
to be more and more requirements or
testing,” he says.
Some analysts avor a low-risk
strategy known as pairs trading com-
monly employed by sophisticated
investors and hedge unds. It works
like this: You look or pairs o stocks,
usually in the same industry, that
have very dierent prospects. Thenyou buy the better stock and short
an equal dollar amount o the more
troubled company’s shares.
Charles Kirk, a proessional inves-
tor and author o the Kirk Report
blog, screened Chinese equities that
trade in the U.S. to look or possible
pairs. The screen looked at company
undamentals as well as recent trad-
ing patterns.
Kirk came up with 15 high-risk
and 15 low-risk stocks. Over the past
three weeks, the low-risk group hasoutperormed the high-risk stocks by
11 percentage points. Possible pairs
trades rom Kirk’s list include buying
Shanda Interactive Entertainment
or Ctrip.com rom the low-risk list,
while shorting Hurray! Holding or
UTStarcom rom the high-risk side.
For the more bearish, ProFunds, a
Bethesda (Md.)-based money manag-
er, has just introduced an exchange-
traded und designed to move twice
as much per day in the opposite direc-
tion o the FTSE/Xinhua China 25, an
index o 25 Chinese stocks that trade
in the U.S. It includes giants China
Mobile, PetroChina, and the Indus-
trial & Commercial Bank o China. “I
you have the view that there’s a China
bubble, this is a way to turn that to
your advantage,” says ProFunds CEO
Michael L. Sapir. It isn’t as risky as
shorting stocks, a strategy in which
losses are unlimited i the stock price
keeps rising. ProFund buyers can’t
lose more than the amount they
spend on the ETF. And ETFs can be
held in retirement accounts where
shorting stocks is prohibited. ^
if you want toplay in china...Srags for maagg rsk a ovra mark
stocks may be overvalued, but the economy
is growing. one fund manager’s advice:
“go with the companies that sell to china”