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Stock Strategist

What Every Would-Be Investor Should Know about China

We share our thoughts after an extended visit to the rapidly growing country.

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As I wrote in the April issue of StockInvestor, Morningstar has an office in mainland China in Shenzhen, a city just over the border from Hong Kong. I spent little over a month there earlier this year, ostensibly to help train some of the stock analysts we've hired here to cover Chinese stocks for us. But my main motivation for going was to gather as many insights as I could about the booming Chinese economy via an immersive learning experience. This article will focus on my insights, as well as those accumulated by my colleagues who have also made the journey.

First, some background information. Much of what you hear about the boom is absolutely true. Signs of the exploding economic activity are everywhere. While Shenzhen is a boom town in itself and growing faster than China as a whole, it is still quite shocking to see the literally hundreds of construction cranes that dot the skyline. You think Las Vegas is a boom town, roughly tripling in size and adding 1 million residents over the past 25 years? Consider Shenzhen, which has gone from 300,000 to more than 12 million (and still going strong) since it was set up as a "special economic zone" in 1980 meant to attract business from around the globe. Companies are migrating here, meeting a mass migration of people from China's rural areas to urban areas.

In the cities (where I spent nearly all of my time), the technology and lifestyle is really not much different than what you would find anywhere in the developed world. People are driving cars, talking on cell phones, using PCs, and watching high-definition televisions. One advantage that China has is that it is "leapfrogging" many technologies. For instance, when a Chinese person goes online for the first time, it is often not dial-up, but rather broadband. Forget wired telephones, they all seem to have advanced cell phones.

Visiting China in 2007 is a bit like visiting Silicon Valley in 1999 at the height of the dot-com era. Things are happening at light speed, and the economy is white hot here, but caution is certainly warranted. The economy has grown at a 10%-13% rate for several years in a row, and on a purchasing power parity basis (excuse the economist-speak), the Chinese economy now has a GDP of about $10 trillion, trailing only the EU and the U.S. at roughly $13 trillion each. (After adjusting for currency effects, the actual value is much lower, but that's another story.) The bottom line is that like it or not, you cannot be a student of the modern world economy without taking time to study China. It is simply too large a force to be ignored.

So what's driving this growth? The ingredients in the explosion are 1.3 billion people (it's the world's most populous nation, accounting for about 20% the global population) meeting a steadily liberalizing economic environment, fueled by copious amounts of foreign capital looking for cheap labor, helped along by the technological "leapfrogging" I spoke of earlier.

So with all this growth, did my expedition yield any hot stocks that are no-brainer fat pitches for the Hare Portfolio? While I did learn of many interesting firms, unfortunately, everything I found was either too scary (far outside my circle of competence or risk tolerance zone), too expensive (I was there late in the boom), or cannot easily be purchased by foreigners. I'm still glad I came. Though there may be slim pickings among Chinese stocks with attractive risk/reward ratios, learning about an area is always worthwhile, because then we will be prepared when market conditions change and prices come down. As Louis Pasteur famously said, "Fortune favors the prepared mind."

With this idea, several of the stocks I dug into while there are worthy of keeping on the radar, including  Guangshen Railway (GSH) (mainland railway monopoly in the Hong Kong-Shenzhen-Guangzhou region),  China Mobile (CHL) (dominant mobile phone firm currently adding 5 million subscribers per month) and  China Life (LFC) (incumbent life insurance titan, serving a barely penetrated market).

China's Competitive Advantages
Clearly, China has some competitive advantages relative to the rest of the world, otherwise companies would not be expanding in China at a break-neck pace. There is no doubt that China is a very low-cost provider, but why is that?

I think one reason has to do with the country's lax environmental restrictions, or at least a willingness to accept a greater share of the world's pollution. One of the benefits of America exporting its manufacturing capacity to China is that we have also exported many of our environmental problems. Smokestacks may be going dormant in the U.S., but they are blowing strong here. And you can tell! I am not exaggerating when I say I did not see blue sky a single time my entire time here, only clouds or brown haze that at times literally burned the sinuses.

I should also note that the tap water is not potable. My doctor correctly recommended I treat the water here like I would in Mexico. And recycling? While I often saw poor migrants salvaging, only at a handful of high-profile locations did I see small (and mostly empty) recycling bins. So you can forget the stories about an emerging environmental disaster happening here. It has already happened.

Also wanting here are the safety standards of more-developed countries. When you have cabs without seatbelts, much less airbags, traction control, etc., of course they are going to cost less. And if the safety standards in the factories are anything like they were on the streets I observed (a good bet) and the same dynamics apply� it means far less safety, far lower cost. It should be little wonder why, for instance, China's coal mines and roads are several-fold more lethal places than in America.

Of course, one of China's largest advantages is its people, all 1.3 billion of them, or 4 times that of the U.S. and Canada combined. Ponder the fact that if China got to a point where its economic output per person reached half of what it is in America, the Chinese economy would be double the size of ours. And make no mistake, these are people who are generally well educated, hungry for a modern lifestyle, and excited to be able to lift themselves up to compete on the global stage.

This is clearly a country very, very long on manpower. The signs of the ridiculously inexpensive labor smack you in the face. To get from my hotel's front door to the elevators, I got to say "ni hao" (hello) to no fewer than four "greeters" manning the lobby at all times. There are police or security guards just standing around on what seems like every other corner. Every restaurant and retail outlet seems overstaffed by threefold or more. Street sweepers literally sweep with brooms. This huge excess pool of labor is great for businesses, but not so good for the wage-earners.

One final advantage has to be the government. Love or hate the communists, one of the benefits they bring to the country is that decisions can be made very quickly without debate, and things can and do get built in a flash. Infrastructure projects like dams, roads, subways, airport runways, etc. get built at lightning speed without lengthy litigation processes concerning environmental impacts or trampled property rights.

China's Disadvantages
While China has some key advantages versus the rest of the world, it still has its share of things that hobble its competitiveness. The largest of these, in my opinion, is imperfect capital allocation. While China has indeed moved to a market economy, with such a strong central government that remains majority shareholder in many companies, there are still forces other than pure market forces meaningfully at work.

In all free markets, as Adam Smith penned 300 years ago, there is an invisible hand that controls where capital is invested and goods are consumed. This hand is quite strong in America, but it is only operating with three fingers in China. It's far better than the Soviet style of communism that bankrupted that country, but there is still a ways to go before capital is freely and efficiently flowing.

I will also point out that a very strong, essentially unelected central government, unencumbered by a free press, also inherently lends itself to corruption, nepotism, and other systematic inefficiencies. Our system in the U.S. may be slower in making things happen with all of our checks and balances, but our system is much more free of these problems.

And while China has clearly mastered the art of making things, this is still a country that has little intellectual property of its own. Going from "Made in China" to "Invented and Designed in China" will be a difficult transition, if it can be made at all. Right now, China has a major manufacturing cost advantage, but the skill and creativity advantages still reside in the Western Hemisphere.

Finally, it should be noted that as the world "goes flat," it is inevitable that some of China's cost advantages will dampen. As the standards of living rise in China, so too will the wages the workers demand as well as other costs of doing business. Signs of meaningful inflation are already cropping up, and I am betting they will only get worse. I fully expect my next visit to China to be much more expensive, and not just because the currency peg to the dollar has moved.

The Issues Facing Investors
For those considering investing directly in China, there are some large issues that should be kept in mind. The most important thing to remember is that the Chinese government still holds all the cards. In a very large number of Chinese firms, the government is still the controlling shareholder as well as regulator, which creates all sorts of sticky conflicts of interest. Thus far, the government has been fairly even-handed in its dealings, but there is nothing structurally present to limit the government's power. All else equal, one should require a larger margin of safety investing in China than investing in more developed economies with well-established regulations and property rights.

The capital markets in China are also in their adolescence and are not nearly as developed as in the rest of the world. First, the Chinese markets do not have the mechanisms to allow participants to short stocks and profit from declines. Lacking this important check makes the markets here inherently less efficient. And forget the fair disclosure rules we have in the states. Companies usually give preferential disclosure of information to their favored investors.

Pile on top of this the fact that individual domestic Chinese investors are not allowed to invest outside the country. Then consider that the interest rates paid by the Chinese banks on deposits are very low, around 2.5%, and that this is one of the only other investment options for domestic capital. And of course, this is a country that is currently flooded with capital, and because of the massive trade imbalances, capital is still rushing in. So we essentially have a closed system where capital is coming in and has a hard time escaping. With such low costs of capital, is it any wonder that the returns investors are requiring here are plummeting and the Chinese stock market is inflating like mad?

One piece of evidence is quite telling on just how inflated the domestic stock market in China has become. Many companies list their stock on two stock exchanges--"A" shares on the domestic exchanges, and "H" shares in Hong Kong. In theory, the shares have equivalent economic interests. Historically, the two share classes traded at more or less parity with only minor differences. But at the time I originally wrote this, every single company with a dual listing had its A shares trade at a premium to its H shares. Sometimes the premium is a whopping 75% or more! (The recent Chinese "correction" has dissipated some of this, but not all.)

The Chinese government is trying to further liberalize its capital markets to alleviate some of the pressures, but it will take time. The government took one step by raising interest rates earlier this year. Another step that looks like it is almost sure to take is moving the yuan's peg to the dollar down further. I've got to believe that if the yuan were totally unpegged from the dollar, the yuan would soar and the dollar would fall precipitously on a relative basis. This would be very good for those who invested some of their dollars in yuan-denominated assets, which is a very obvious reason for us to be interested in Chinese assets.

And of course, whenever you have an economy that has grown at a double-digit rate for nearly a decade, it is only natural to expect the economy to take a breather to consolidate gains and work off some of the excesses that have been built up in the boom. I am still strongly bullish on the Chinese economy in the long term (just like I am on the U.S. economy), but I fully expect some growing pains here and there.

As you can tell, investing directly in China (or even indirectly via funds) involves many complicated issues. But again, the opportunity is just too big to ignore, and the issues can be understood with a little effort. Though I found no fat pitches from China at the moment, at least I have significantly shrunk the size of the Chinese stocks that used to fall into the "too hard" bin.

A version of this article appeared in the April issue of StockInvestor.

Paul Larson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.