Playing With Fire

Forget the new zillionaires. There are many good reasons to resist playing with fire in the China craze.

When the ducks are quacking, the saying goes, Wall Street feeds them, and right now we ducks are quacking for a steady diet of China-related investment opportunities. If China’s economic miracle ends the way many do (e.g., Japan), we will blame Wall Street for our misery. But we should proceed with our eyes open.

China is the hottest business and investment story on the planet. The 21st century has already been proclaimed the “Chinese century,” and shock waves from China’s frenzied entrepreneurialism, manufacturing prowess and low-cost labor are rocking industries throughout the world. As in every gold rush, fortunes are being made, and each new tale of a freshly minted zillionaire fuels the China fever. China is the biggest growth story in history. We can’t afford to miss it!

Well, we aren’t going to miss it, because, like other economic tidal waves (the Internet, for example), China will affect us whether we invest in the country or not. And before we rush in, we should remember that the Internet craze melted down not so long ago, and one other megatrend, real estate, may yet do the same. But we wouldn’t be human if we didn’t dream, and China’s size and three decades of spectacular wealth creation certainly offer much in the way of inspiration. So how can we cash in?

The safest but most labor-intensive China investment strategy is to move to the country, learn the language(s) and settle in for a decade or two. This way, you can be close to the action, and if you don’t strike it rich on your own you can sell your China expertise to someone else. If you’re not up for this level of commitment you can buy China-related securities, either directly or through funds.

For example, there are the “A shares” and “B shares” of companies listed on China’s domestic stock markets in Shanghai and Shenzhen. However, the A shares are tough to buy and the B shares offer a limited selection. Given the embryonic state of China’s legal, accounting and regulatory systems, this is probably good: your odds of hitting the jackpot in Shanghai or Shenzhen are worse than in Las Vegas.

Then there are the “H shares” and “red chips,” Chinese companies listed in Hong Kong. Most of these companies are controlled by the Chinese government, but they tend to be real companies (as opposed to some of the horrors listed in Shanghai and Shenzhen). If you don’t want to deal with the hassle of global trades, cross-border ownership, foreign taxes and currency conversion, you can also buy the American depositary receipts (ADRs) of Chinese companies listed in New York. These companies must meet American reporting requirements, and are therefore as scrubbed as any China securities (which isn’t saying much).

If you go this last route, of course, sometimes what you will be buying is not the actual stock of a Chinese company, but the stock of, say, a Cayman Islands company that has a contractual relationship with a Chinese company, one that you must pray will last longer than many contractual relationships in China (where contracts are often viewed as a snapshot of an ever-evolving arrangement). The same Chinese companies also occasionally list stock simultaneously in Shanghai, Hong Kong and New York, and trade at different prices on each market—so you might end up paying more for the same asset than a professional investor with global reach.

Which brings up a key point, one that is often lost in the din of do-it-yourself investing propaganda: you can buy China stocks, —if you really want to, but there is absolutely no reason for you to do so. On the contrary, there are dozens of reasons for you not to do so, starting with the competition.

China is hot, which means that lots of professionals are investing in the country, and most of them probably know more about it than you do. This may sound heretical: in the United States, we love to imagine that with an Internet connection and a few minutes of spare time we can go head-to-head with full-time professionals. Sadly, this is ludicrous. We can’t compete on the PGA Tour after hitting a couple of buckets of range balls, and we shouldn’t expect to be able to compete against professional investors after reading a couple of SEC filings—especially in an emerging market half a world away.

Professional China investors live in China, speak Chinese, visit Chinese companies, drink baijiu with Chinese managers, schmooze with Chinese lawmakers and party members and have dozens of China-focused Wall Street analysts calling them day and night with every crumb of China-related information they find. These investors have multimillion-dollar research budgets, deep China expertise and armies of Chinese analysts, and many were born and raised in the country (before being educated at Harvard et al.). Once in a while we may uncover some gem that these experts miss, but chances are slim that we can do it consistently.

So if buying individual China stocks sounds nerve-racking, you can (wisely) opt for a mutual fund. But here, too, beware. Even dime-a-dozen U.S. funds often charge egregious fees, and fees on foreign ones can be especially steep (2 percent of assets per year, or more). Also, although many China funds have posted excellent performance over the past few years, this performance may have been the result of market trends or luck (the H shares, for example, have had a strong three years). It may be true, as some argue, that China’s markets are so inefficient that most managers can deliver above-market performance (contrary to the case in the United States, where they can’t), but the jury is still out on this. In any event, you’re probably best off seeking low-cost active funds, passive index funds or exchange-traded funds (ETFs).

The paradox of China investing these days is that even though the economy is screaming along, China’s domestic markets are sucking wind—and have been for years. Economic performance and stock performance do occasionally diverge, but China’s markets are also saddled with other problems, including big blocks of untradable state-owned shares, high valuations and limited market access. The six-year downtrend has destroyed investor confidence, and China’s once manic little guys are feeling surly and discouraged. Normally, this is an excellent time to buy, but in the case of China’s markets the decline has only rendered stocks “expensive” instead of “outrageous.” Data are hard to come by, but most reports suggest that they’re still miles from “cheap.”

In Hong Kong and New York, on the other hand, China stocks may actually be cheap. Merrill Lynch, for example, estimates that the Hong Kong H shares are trading at about 11 times 2005 estimated earnings, versus a long-term U.S. average of about 16 times earnings, and this valuation appears attractive for long-term investors. Whether this is the result of the market’s anticipating an economic slowdown or simply an appropriate discount to compensate for China’s risks and uncertainties, is unclear, but at least the stocks don’t appear to be incorporating much of a China premium.

But this still doesn’t mean that it makes sense to buy them. Despite the attractiveness of China’s long-term story—presumed future economic superpower and so on—its stocks are still just a subset of a minor asset class: emerging-market equities. As such they should constitute, at most, only a tiny fraction of the average portfolio. China, moreover, is only one of dozens of emerging markets—it currently represents only 7 percent of the MSCI Emerging Markets Index, for example—so the total China exposure should usually be far less than 1 percent of assets. Most investors can get all the China exposure they need by owning U.S. companies that do business there or small helpings of Asian and emerging-markets funds.

(It has been suggested that investors can also “play China” by buying commodities, but if you do this, please recognize that you are not “investing in China” but “trading commodities,” which is one of the riskiest and most difficult market endeavors there are.)

If you simply can’t stand not having some direct China exposure, then the best bet is probably a low-cost, diversified country fund or ETF. Before pulling the trigger, however, remember that in addition to the possibility of posting impressive gains, you may lose most of your money and/or sit stagnant for decades. Remember Japan, the last great Asian investment opportunity? Its chief stock index, the Nikkei, currently trades at approximately one quarter of its 1989 peak. China’s stocks are much less expensive now than Japan’s were then, so the downside is probably not so extreme, but such are the perils of chasing economic miracles.

And then there’s another instructive comparison, one that lays out the potential upside if things in China go right. Commentators often compare China today to the United States 100 years ago. In those days America was also an “emerging market,” so it’s worth reviewing how its stock markets have performed.

In the past 200 years, U.S. stocks have returned an average of about 10 percent per year (7 percent after inflation). If China continues to roll, this return is probably in the neighborhood of what long-term China investors can expect. But be careful: “long term” really means long term (30 years). The performance of the U.S. economy in the 20th century was breathtaking. Yet in the same period, U.S. stocks went through three major bull markets and three major bear markets, and devastating crashes wiped out generations of investors along the way. Despite the economy, in other words, for vast stretches of the century—1901 to 1920, for example, or 1966 to 1982—U.S. stocks were dogs. China may or may not turn out to the “the next United States,” but regardless, it won’t be a smooth ride.

Blodget is writing a series for Slate.com on the China gold rush, from which this article is adapted. A former top-ranked Wall Street analyst, Blodget was a party to the global settlement of a regulatory investigation into conflicts of interest at brokerage firms, which precludes him from working in the securities industry.

By Henry Blodget –

Source: Newsweek

Photo credit: karendesuyo via Visual hunt / CC BY