china inc. is out on a limb

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china inc.is out on

a limb

BUSineSSWeeK I NOVEM BER 26, 2007



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.

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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



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


Data: Bloomberg Financial Markets

CSI 300 INDEX

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a l e x n a b a u m

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in depth


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”

china inc. is out on a limb

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