062

china inc.
is out on
a limb

BUSineSSWeeK I NOVE M B E R 26, 2007

 in depth

063

By Frederik Balfour and China’s stocks are sky-high. And Chinese companies are
Chi-Chu tschang
illustrations huge investors. So guess what happens when the markets
by Alex nabaum
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 sus-
pect, 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 invest-
ments outside companies’ core businesses—which in al-
most 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

064
have no cash basis,” says Ding Yuan, a
professor of accounting at China Eu-
rope International Business School
in Shanghai. “It’s really frightening.”
Scarier still is what could hap-
pen 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 ear-
nest, companies will have to report
these portfolio losses on their in-
come statements, depressing their
earnings. That, in turn, could hurt
their own stock prices, pushing the
market down both further and fast-
er. “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 by 163 companies a year earlier. Morgan An investor
red when those markets collapsed. Stanley figures “noncore” earnings from in Chengdu
checks out stock
To see how big an impact investment income can have stock, real estate, and other ventures ac- prices at a local
on earnings, consider the Youngor Group, which has some counted for 54.1% of profits in China’s brokerage
$800 million in annual sales. Since the garment maker was health-care sector and 64.6% in the con-
founded in 1979, Ningbo-based Youngor has grown into one sumer goods sector.
of the country’s top-selling apparel brands. But these days In China, few investors possess the ability to comb through
those operations pale in significance beside its stock port- financial statements and distinguish a company’s operating
folio. Youngor’s holdings include shares in China Life, Bank earnings from its stock plays. “People overestimate Chinese
of Ningbo, and Citic Securities, the country’s largest broker investors’ sophistication,” says Jerry Lou, head of China
and a red-hot stock in its own right. Gains on these shares research at Morgan Stanley. “Somebody needs to point out
helped Youngor book $223.6 million in investment income that the emperor has no clothes.”
for the first nine months of the year, accounting for 98.5% of Professor Ding cites the case of Black Peony, a textile com-
overall earnings. pany, 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 de-
pendence on Citic shares and other
CHINESE STOCKS’ almost all of it from gains in shares
like Air China, dividends from
equities? A member of Youngor’s RAPID CLIMB other stocks and payouts from af-
investment department, who re- filiates. Meanwhile, its core textile
6,000
quested anonymity, downplays the 5,000
business is struggling. “They’re not
investments as “just a supplement.” 4,000
CSI 300 INDEX controlling any costs because life is
The company continues to load up on 3,000
easy,” says Ding. Wang Panda, vice-
shares, though. Hoping for a repeat 2,000
chairman of Black Peony, admits
of its hit with Citic, Youngor has even 1,000 his business did not do well. But he
applied to regulators to participate in 0 defends his investments, saying he
JAN. 6, '06 JAN. 5, '07 NOV. 14
a secondary offering of Haitong Se- has put much more money into af-
(top) evens lee/colorchinaphoto

Data: 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 com-
Haitong’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


066
if you want to
play in china...
Strategies for managing risk in an overheated market
By Aaron Pressman
If you’re worried about investments
in China, you’re in good company.
Last month, Warren E. Buffett liqui-
dated 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. 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 for years. That’s
why Mark Coffelt, manager of the
BUSINESSWEEK I NOVE M B E R 26, 2007
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 plagu-
ing 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”
in depth
Some analysts favor a low-risk
strategy known as pairs trading com-
monly 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 inves-
tor 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 trad-
ing 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 manag-
er, has just introduced an exchange-
traded fund designed to move twice
as much per day in the opposite direc-
tion 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 Indus-
trial & 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. ^
alex nabaum