china inc. is out on a limb

BUSineSSWeeK I NOVE M B E R 26, 2007

in depth


By Frederik Balfour and Chi-Chu tschang
illustrations by Alex nabaum

China’s stocks are sky-high. And Chinese companies are huge investors. So guess what happens when the markets backslide and balance sheets go into free fall

By now every investor on the planet is trying to handicap what happens when China’s scorching-hot stock markets finally start to cool off. The conventional wisdom is that China’s greenhorn individual investors will take the hit, while corporate China—the companies that make shirts, build ships, and run utilities—won’t feel much at all. The real economy these companies operate in is far too strong to be affected by stock wobbles, goes the argument. The price of corporate shares may fall, but underlying earnings will power on.

That line of argument, though, is looking suspect, for the simple reason that companies big and small are now playing the markets with abandon, using corporate funds to invest in each other’s initial public offerings and bolster their bottom lines. Although figures are hard to pin down, Morgan Stanley figures a third of reported corporate earnings in China stem from investments outside companies’ core businesses—which in almost all cases means plowing money into stocks. “It’s quite dangerous for these Chinese companies because these gains

NOVE M B E R 26, 2007 I BUSineSSWeeK

in depth


have no cash basis, says Ding Yuan, a ” professor of accounting at China Europe International Business School in Shanghai. “It’s really frightening. ” Scarier still is what could happen if the stock markets head south. Shanghai is more than 700 points off its all-time high of 6,124, reached on Oct. 16, though as of Nov. 14 it was still up 102% for the year. If and when stock prices start to fall in earnest, companies will have to report these portfolio losses on their income statements, depressing their earnings. That, in turn, could hurt their own stock prices, pushing the market down both further and faster. “It’s a replay of what happened in Japan during their bubble,” says David Webb, a Hong Kong-based corporate governance expert and non-executive director of 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 founded in 1979, Ningbo-based Youngor has grown into one of the country’s top-selling apparel brands. But these days those operations pale in significance beside its stock portfolio. Youngor’s holdings include shares in China Life, Bank of 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 for the first nine months of the year, accounting for 98.5% of overall earnings.

An investor by 163 companies a year earlier. Morgan in Chengdu Stanley figures “noncore” earnings from checks out stock stock, real estate, and other ventures acprices at a local counted for 54.1% of profits in China’s brokerage health-care sector and 64.6% in the consumer goods sector. In China, few investors possess the ability to comb through financial statements and distinguish a company’s operating earnings from its stock plays. “People overestimate Chinese investors’ sophistication,” says Jerry Lou, head of China research at Morgan Stanley. “Somebody needs to point out that the emperor has no clothes.” Professor Ding cites the case of Black Peony, a textile company, as an example of what happens in a hot market. In the first half of this year, Black Peony hooked on equities recorded profits of $5.8 million, Is Youngor concerned about its dealmost all of it from gains in shares pendence on Citic shares and other like Air China, dividends from equities? A member of Youngor’s other stocks and payouts from afinvestment department, who refiliates. Meanwhile, its core textile 6,000 quested anonymity, downplays the business is struggling. “They’re not 5,000 CSI 300 INDEX investments as “just a supplement. ” controlling any costs because life is 4,000 The company continues to load up on easy,” says Ding. Wang Panda, vice3,000 shares, though. Hoping for a repeat chairman of Black Peony, admits 2,000 of its hit with Citic, Youngor has even his business did not do well. But he 1,000 applied to regulators to participate in defends his investments, saying he 0 JAN. 6, '06 JAN. 5, '07 NOV. 14 a secondary offering of Haitong Sehas put much more money into afData: Bloomberg Financial Markets curities, whose shares have rocketed filiates than the stock market. “We 885% since its first IPO. have diversified,” he says. By increasing the number of available shares, IPOs like Until recently banks lent freely at low rates to bankroll comHaitong’s have amplified the role that stock investments now panies’ investment portfolios. Now regulators are trying to play in companies’ income statements. Wind Info of Shang- stem the lending by increasing bank reserve requirements. But hai, which provides financial data on listed companies in those tempting IPOs keep coming, and corporate investors are China, estimates that as of June 30, 494 listed companies had still lining up. No one inside China Inc., it seems, wants to think stock market holdings worth $45.6 billion, vs. $2.3 billion held about what happens when the bubble bursts. ^


BUSineSSWeeK I NOVE M B E R 26, 2007

(top) evens lee/colorchinaphoto

in depth

Some analysts favor a low-risk strategy known as pairs trading commonly employed by sophisticated investors and hedge funds. It works like this: You look for pairs of stocks, usually in the same industry, that have very different prospects. Then you buy the better stock and short an equal dollar amount of the more troubled company’s shares. Charles Kirk, a professional investor and author of the Kirk Report blog, screened Chinese equities that trade in the U.S. to look for possible pairs. The screen looked at company fundamentals as well as recent trading patterns. Kirk came up with 15 high-risk and 15 low-risk stocks. Over the past three weeks, the low-risk group has outperformed the high-risk stocks by 11 percentage points. Possible pairs trades from Kirk’s list include buying Shanda Interactive Entertainment or Ctrip.com from the low-risk list, while shorting Hurray! Holding or UTStarcom from the high-risk side. For the more bearish, ProFunds, a Bethesda (Md.)-based money manager, has just introduced an exchangetraded fund designed to move twice as much per day in the opposite direction of the FTSE/Xinhua China 25, an index of 25 Chinese stocks that trade in the U.S. It includes giants China Mobile, PetroChina, and the Industrial & Commercial Bank of China. “If 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 if 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 to play in china...
Strategies for managing risk in an overheated market
By Aaron pressman

BUSineSSWeeK I NOVE M B E R 26, 2007

alex nabaum

If you’re worried about investments in China, you’re in good company. Last month, Warren E. Buffett liquidated the last of his stake in oil giant PetroChina, just weeks before the company staged a spectacular share offering on the Shanghai exchange. “We never buy stocks when we see prices soaring, the Oracle of Omaha ” told reporters on a trip to China at the end of October. Chinese stocks have certainly soared. The benchmark CSI index is up more than 152% year to date. And a flood of Chinese companies have gone public as ADRs, or shares on U.S. exchanges, with six that have more than doubled in price over the past year. So how do you play the whitehot 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 for years. That’s why Mark Coffelt, manager of the

Empiric Core Equity Fund, advises clients to “go with the companies that sell to China. He favors Korean steel ” producer Posco and mining giant BHP Billiton, both of which benefit from China’s demand for industrial materials. There are even ways for investors to profit from the quality issues plaguing some Chinese exports. European companies such as Bureau Veritas, InterTek Group, and SGS see higher revenues from increasing demand for testing of Chinese exports, says Barry P. Dargan, manager of the MFS International Growth Fund. “They’re growing very well, and there are going to be more and more requirements for testing, he says. ”

stocks may be overvalued, but the economy is growing. one fund manager’s advice: “go with the companies that sell to china”

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