Great Chi­nese dream: myth or re­al­ity?

Maybe just an­other BRIC in the wall…

Finweek English Edition - - Creating wealth - SHAUN HAR­RIS

A RE­CENT COVER of Time mag­a­zine la­belled China the “Dawn of a new dy­nasty”. It’s hard to dis­agree. China has be­come the world’s in­dus­trial and com­mer­cial gi­ant, prop­ping up some smaller coun­tries’ economies (and com­mod­ity prices) through its ag­gres­sive im­port pro­gramme.

Not sur­pris­ingly, for­eign in­vest­ment into China has been huge – US$53bn (R384bn), ac­cord­ing to the latest fig­ure for 2005. There’s no dis­put­ing the growth po­ten­tial in China, but some sea­soned in­vest­ment pro­fes­sion­als in SA are ques­tion­ing what they see as a blind, head­long rush into Chi­nese as­sets and com­pa­nies by West­ern in­vestors. There are dan­gers they feel could end in tears.

But so what if rich Amer­i­can and Euro­pean in­vestors and com­pa­nies are pil­ing into China? Well, it’s also an is­sue for South African in­vestors, many in awe of the Chi­nese story and be­ing en­ticed into BRIC, BRICK and BRICKS (Brazil, Rus­sia, In­dia, China, Korea and South Africa) funds that in­clude Chi­nese eq­ui­ties.

“It al­ways both­ers me when ev­ery­one sings from the same hymn book. In­vest­ments in China started wor­ry­ing me last year,” says Rowan Wil­liams-Short, in­vest­ment di­rec­tor at Ned­group In­vest­ment Ad­vi­sors in Bri­tain.

Wil­liams-Short re­cently re­turned to SA to open his own as­set man­age­ment busi­ness, Or­thog­o­nal In­vest­ments (the maths con­cept is com­pli­cated, but it ba­si­cally means “Don’t put all your eggs in one bas­ket”). But Ned­group has asked him to stay on as a con­sul­tant.

Dur­ing his two years over­seas he says he vis­ited more than 1 000 as­set man­agers world­wide and gained a de­tailed in­sight into global in­vest­ing. Says Wil­liams-Short: “The in­creas­ingly hack­neyed growth sto­ries con­cern­ing China and In­dia – re­plete with a new phase Chin­dia, of­ten a har­bin­ger of hubris – seem to have be­come the sta­ple diet of just about ev­ery in­vest­ment con­fer­ence over the past few years.”

A se­lec­tion of his con­cerns with re­gard to China in­clude: • The econ­omy is still cen­trally con­trolled. For ex­am­ple, a max­i­mum price:earn­ings mul­ti­ple for ini­tial pub­lic of­fer­ings (IPOs) was set in De­cem­ber 2001. The strong im­pli­ca­tion is that that in­vites earn­ings ma­nip­u­la­tions to match the set p:e. Quot­ing Marathon As­set Man­age­ment, Wil­liams-Short says the per­cent­age of Chi­nese IPOs whose stated re­turn on cap­i­tal peaked in the year pre­ced­ing the list­ing (be­fore proper scru­tiny by re­spected au­di­tors and be­fore fuller dis­clo­sure re­quire­ments) is 100%. • H shares – in it­self a con­cern, as th­ese are the shares avail­able to for­eign in­vestors and not the reg­u­lar or­di­nary shares. Wil­liamsShort likens it to our old fi­nan­cial rand sys­tem, but adds the change in net in­come mar­gins of such H shares in the four years fol­low­ing new list­ings has been a neg­a­tive 40%. His con­clu­sion: “It would ap­pear that new in­vestors are be­ing duped into giv­ing cre­dence to puffed-out pro forma fi­nan­cial state­ments.” The an­nual new power gen­er­at­ing ca­pac­ity needed to sus­tain China’s re­cent growth rate ex­ceeds the en­tire in­stalled ca­pac­ity in Bri­tain. (And we think we have prob­lems with Eskom’s re­quired ca­pac­ity.) “Such tan­gi­ble pr­ereq­ui­sites, eas­ily enough dis­cov­ered by in­duc­tion, tend to es­cape the no­tice of fore­cast­ers, who rely mostly on ex­trap­o­la­tions of re­cent trends.” Given the vast­ness of China and its mas­sive pop­u­la­tion, ac­cu­rate cal­cu­la­tion of GDP must be more dif­fi­cult than in most coun­tries – yet each quar­ter China is among the first coun­tries to re­lease a GDP growth num­ber. “You could be for­given for sus­pect­ing that rough es­ti­ma­tions and smooth­ing may be used,” he says.

Piet Viljoen, of RE:CM, has also taken a con­cerned look at Chi­nese eq­ui­ties, fo­cus­ing on re­cent bank IPOs. As part of a larger study con­cern­ing “very large, very over­priced IPOs” in global mar­kets, the re­search on the RE:CM web­site iden­ti­fies Chi­nese banks as one of three cur­rent world in­vest­ment themes (the oth­ers are in­fra­struc­ture plays and private eq­uity).

The last two sound very familiar in SA’s in­vest­ment land­scape; but on Chi­nese banks, RE:CM notes the rise of 2,5bn new con­sumers in China (all of whom need a bank loan). That makes it not hard to un­der­stand the at­trac­tive­ness of such as­sets.

“Cur­rently, Chi­nese banks are en­joy­ing a pe­riod with a good fun­da­men­tal back­drop: their huge bad debts have been re­moved by the gov­ern­ment, their eq­uity re­cap via the IPO mech­a­nisms has al­lowed them to grow their loan books rapidly (again) and glob­ally in­ter­est rates are low. But does the val­u­a­tion stack up?”

The an­swer seems clear from the av­er­ages that RE:CM has com­piled for large de­vel­oped mar­ket banks, SA and Chi­nese banks in the ta­ble be­low.

At face value, Chi­nese banks look fairly

ex­pen­sive, says RE:CM. How­ever, it notes that the num­bers don’t take po­ten­tial growth rates into ac­count. “But then again, nor do they take po­ten­tial bad loans that are cur­rently be­ing writ­ten ei­ther.”

The as­set man­ager’s con­clu­sion is that it’s no sur­prise Chi­nese banks are is­su­ing record amounts of stock to in­vestors and are be­ing paid a nice price. Need­less to say, Viljoen isn’t in­vest­ing in any of th­ese new list­ings.

Wil­liams-Short says even for in­vestors loath to be­lieve or pay heed to his con­cerns listed above, they “need to con­sider an is­sue that they might nor­mally take for granted – that of ba­sic reg­u­la­tory pro­tec­tion for share­hold­ers”. He quotes some excerpts taken from the “small print” of a re­spected fund-of­fer­ing doc­u­ment in­vest­ing in Chi­nese eq­ui­ties. • “…suit­able for in­vestors who are will­ing to with­stand the to­tal loss of their in­vest­ment…” “Com­pa­nies quoted on Greater Chi­nese stock ex­changes are ex­posed to the risks of ex­pro­pri­a­tion of as­sets or na­tion­al­i­sa­tion.” • “…should any tax be payable ret­ro­spec­tive-

ly, the net as­set value will be ad­justed to the ex­tent that ex­ist­ing share­hold­ers are li­able.” Wil­liams-Short adds that while he’s pre­pared to con­tem­plate that he might be wrong or mis­guided about the ex­tent of China’s eco­nomic growth, that’s less in­ter­est­ing to in­vestors than the de­bate on the mer­its of buy­ing listed Chi­nese shares.

And Wil­liams-Short says Chi­nese eq­ui­ties are “to­tally in­ap­pro­pri­ate” for South African in­vestors. “Emerg­ing mar­ket in­vest­ments make up about 10% of the world’s to­tal in­vest­ments. SA is around 1%. Do you want to di­ver­sify from that 1% into the other 9%? It doesn’t make sense.”

He says while in­vest­ment dan­gers may not be as ex­treme in In­dia as in China, he’s also wor­ried about In­dia “be­cause it’s the flavour of the day”. It’s all the hype that con­cerns Wil­liams-Short, and he has seen it be­fore: south-east Asia in the lat­ter half of the Nineties (the Asian Tigers), Y2K, the TMT melt­down.

He quotes Jonathan An­der­son, chief Asian econ­o­mist at UBS, on the Chi­nese econ­omy as “propped up by a po­tent cock­tail of free cap­i­tal dis­torted re­source al­lo­ca­tion”. Says Wil­liams-Short: “The crazed rush by in­sti­tu­tional fund man­agers to of­fer re­tail prod­ucts in­vest­ing in Chi­nese eq­ui­ties – BRIC, BRICK and BRICKS – should sound the largest alarm bell of all.”

And he has told a large in­vest­ment con­fer­ence that it’s enough to make a cau­tious SA in­vestor “shit a brick”.

AVERAGEGE RA­TIOS AND RE­TURNS FOR:

Source: RE:CM

A har­bin­ger of hubris.

Rowan Wil­liams-

Short

Not in­vest­ing in Chi­nese

banks. Piet Viljoen

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