Chinese stocks are different because China is different. There’s the world’s biggest population, of course. But there are many other factors that make China and its stocks different from shares in the U.S. and sometimes unique in the world.
One vital difference: Less than three decades ago, China was a desperately poor, closed country with a moribund Stalinist state-run economy. The ruling Communist Party, shaken by devastation wrought by Mao’s leftist excesses, firmly committed to market-oriented modernization in December 1978. But the Party started with zero knowledge of how to implement a market-based economy open to international trade and investment. And to this day the Party still resolutely chokes off even the smallest challenge to its complete power. All this means China started from the basement with big challenges but with almost unlimited room to grow.
What does this mean to you, when you’re considering putting your hard-earned money into China stocks? The answer is you’ll have to weigh extremely attractive rewards against daunting risks.
The (very) good
*World beating economic growth. Starting from a rock-bottom base, with uncountable areas to improve through economic reforms, China has recorded consistent 7% - 9% GDP annual growth since the early 1980s. Growth reached a dizzying 11% before the global recession started in 2008, thanks largely to an acceleration in economic reforms spurred by entry into the World Trade Organization and to development of a substantial middle class. And the rate of increase in use of metals, oil and other basic materials exceeds GDP growth because of the very low starting level of consumption. China aggressively dealt with the international credit crisis with a massive economic stimulus plan and lavish bank lending. Economic growth was a healthy 8% a year in late 2009.
What it means for stocks. Corporate profits have plenty of room to rise and can underpin strong gains in share prices.
*Asset injections. Virtually all enterprises were wholly owned by the national or local governments 30 years ago. Privatization is an immense and on-going process. Most companies listed on Chinese and/or foreign stock exchanges are spin-offs of huge government ministries or enterprises. These huge organs are continuing to plow assets such as factories or regional operations into listed firms.
What it means for stocks. A company’s assets and profits leap when its parent company injects substantial assets.
*New companies. This is a legacy of the old state-owned economy, like asset injections. Government ministries and enterprises are still spinning off new companies, many of them very large.
What it means for stocks. Investors enjoy a multi-course Chinese feast. For example, big, new Chinese mining companies list regularly on overseas exchanges, according to Andrew Driscoll, Hong Kong-based analyst at CLSA. At the same time, he noted, the number of Western mining companies available for investors is declining due to industry consolidation.
*Different stock markets. China opened stock exchanges in Shanghai and Shenzhen about 20 years ago. The A share market was exclusively for domestic investors, and the B shares only for foreigners. Chinese citizens and companies could not invest in stocks abroad. A shares are still almost completely closed to foreigners, but now many of the same companies are listed in Hong Kong and perhaps in New York, London and other places.
What it means for stocks. Chinese investors have pushed A share prices through the roof (see the page, Scorecard). Now these investors get access to Chinese companies listed abroad, especially in Hong Kong, mainly through backdoor channels. Expectation the Chinese government would approve investment in Hong Kong by Chinese citizens sent Hong Kong stock prices through the roof in 2007. The expectations were soon dashed, and the market plunged. But sooner or later Chinese investors will get access to foreign stocks as China reforms its foreign exchange policies.
The (very) bad
*Lack of market standards. Still a 20-something, China’s market economy falls below the standards of America and other developed nations in many areas. China did not meet the Emerging Markets standards set by the giant California Public Employees’ Retirement System. CalPERS set three country factors (political stability, transparency and productive labor practices) and four market factors (market liquidity and volatility, market regulation/legal system investor protection, capital market openness and settlement proficiency/transaction costs). Before January 2007, emerging market countries had to reach a score of 2.0 or more on a scale based on these factors before CalPERS would authorize investment. China’s score at the time was 1.9.
What it means for stocks. Despite China’s failure to reach market standards, professional and experienced executives at CalPERS took into account consistent improvements and the potential for high growth. In January 2007 CalPERS authorized investment in Chinese stocks (and in four other emerging market countries). But investments will be only on a small scale in carefully selected stocks. That’s a good model for the average investor in Akron and elsewhere.
*Economic uncertainty. Strong economic growth is great for stocks, but many experts insist it’s not going to last. Dangerous bubbles will inevitably pop, they say, in areas such as properties and over production of steel and many other materials. Chinese authorities set off massive bank lending to prop up the economy in the global recession, and the worry is many of the loans were ill-considered and will not be paid back. Again, the legacy of the old state-run economy raises its head. Provincial and city governments tend to finance unneeded airports, factories and other projects to boost local economies and employment. The national government is walking a tightrope, trying to curtail investment enough to prevent economic overheating but not so much as to cause a crash.
What it means for stocks. A precipitous drop in corporate profits would shoot P/E ratios for China stocks into outer space, and investors would bail out en masse. One of the biggest bubbles threatened by a downturn is the Chinese domestic A share market, which rocketed some 90% higher in the first eight months of 2009. You and other regular investors are not directly involved because you can’t buy A shares. But if that market crashes, it will add more pressure on Chinese stocks overseas. These stocks have constructed their own, somewhat smaller bubble in the last year or so.
The (potentially very) ugly
*Political uncertainty. First, we must note that Chinese Communist leaders have done a remarkable, uniquely unprecedented job of maintaining market-oriented economic reforms and growth for more than 30 years. The turmoil leading up to the Tiananmen Square Massacre in 1989 demonstrated the Party’s ruthlessness toward political threats, but did not derail economic reforms. Continued economic growth would go far to forestall significant threats to Party rule. However, local protests against official corruption and other issues are growing more numerous and violent. With no outlet in the media or other organizations for grievances, even a scuffle involving a few people can become a riot lasting days. A big drop in the economy and rise in unemployment would magnify discontent. But authorities have routinely overcome major challenges before, and probably will continue to do so. Political upheaval is NOT likely, and certainly not in the cards in the next few years. But there is no guarantee.
What it means for stocks. Political turmoil and the accompanying economic downturn would crush Chinese stock prices. If the Tiananmen Square Massacre is an example, the crash would be deep, but reforms and stocks would bounce back.
