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A Little Perspective on China

By: Jason Whitby

By: A. Jason Whitby, CFA, CFP®, AIF®

So much attention today is paid to China and its amazing story. With over 1.3 billion people, China is estimated to represent approximately 20% of the world’s population. This means one out of every five people in the world is Chinese. China’s economy has been growing around 10% a year for almost 30 years and today is the second largest global economy after the United States. And few people missed the Olympic Games in which China captured 51 gold medals beating out the USA with 36. There is little doubt that China’s transformation and emergence as a world player has and will continue to be an extremely important and amazing story. But what does this story mean to a prudent investor and what if anything should an investor be doing about China, with emphasis being for an investor, not a trader. Let’s look at some additional information about the Chinese Stock Market and see what kind of perspective it might provide.

Biggest Companies1

China has some of the biggest companies in the world. Matter of fact, as of July 21st 2008, China had three of the top 10 companies in the world, the same as the United States. China has the biggest telecommunication company, the largest bank and the second largest energy corporation in the world. China having some of the biggest companies in the world isn’t a big surprise. But it may surprise you to know how those companies got so big. It wasn’t through market growth but through privatization. Most of China’s big corporations were record setting initial public offerings that magically transformed overnight from a state-owned government organization to a publically traded company. This is comparable to the United States Postal Service going from a government agency to being a public corporation. Now I have no idea if these Chinese companies are good or if they are great or if they will end up being broken into a million different companies like Standard Oil and AT&T. But I can comfortably say that China’s Stock Market is represented mostly by very, very big companies and that the Chinese government continues to be an alarmingly large shareholder of these companies. Therefore, most public investments that are available to the typical investor are not “ground floor” investments or even “getting in early”. Some may even call it a “little late to the party”.

Biggest Banks1

China has the biggest bank in the world, Industrial and Commercial Bank of China, ICBC. Actually, China has three of the top five banks in the world: ICBC, China Construction Bank Corp and Bank of China. The United States has one, JPMorgan, and Japan doesn’t have any. Perhaps there are only a few monstrous Chinese banks being compared to a bunch of little American banks, but that isn’t my interest. What does interest me is that ICBC is the world’s biggest bank by market value, just three years after receiving a $15 billion government bailout. It recently reported having roughly the equivalent number of clients as the combined population of Russia and Canada. But it is even more interesting to me and perhaps more important to remember that China is communist, a one party system which doesn’t lend itself to being open and transparent with information. So if the United States and other developed nations are having major issues with their financial systems, are we to believe that the Chinese system is actually stronger, more honest and less corrupt? Are we really to believe that the Chinese regulators and corporate managers are less likely to mislead the public investors? Are the financial statements of banks from communist China any more or less believable? Given all of the concern we have with transparency and corporate integrity right here in the USA, I would think it is extremely wise to be equally skeptical when considering the data and facts coming out of China.

Chinese Investable Assets

So you still feel you are getting in early and can trust the numbers, how can you actually invest in China? That is actually pretty difficult since the stock market is soooo small. That is right. China has some of the largest companies in the world but its stock market is the same size as Italy’s2. As of December 31st 2007, the entire public stock market in China was worth $637 Billion compared to that of the US at $15.7 Trillion. China’s entire stock market is worth just twice that of Microsoft. What this means it that there is very little depth to China’s stock market. You have approximately the same amount of public investment options in Spain as you do in China. For a closer look, let’s examine the holdings of a popular Chinese focused investment, FXI, which is the iShares FTSE/ Xinhua China 25 Index. This investment has 43% in financial services, 25% in energy and 20% in telecommunication with the top 10 companies representing more than 60% of the index. So China has a few big companies making up a very small stock market. Additionally, investing in China has been getting a lot of attention and media hype. There is a saying in economics that I feel is appropriate here, “Too much money chasing too few goods” causes price inflation. I’ll let you make your own judgment call on whether or not too much money is chasing too few Chinese stocks. I’m only trying to highlight just how small the market is and how few investment options there really are in China for you to even consider. Additionally, you should be aware that small stock markets come with small exit doors. So if the monies start to rush out of China, things could get ugly very quickly.

Putting the C in BRIC

My intention is not to pick on or single out China especially since similar points can be applied to India, Russia and perhaps, to a less extent, to Brazil. The BRIC (Brazil, Russia, India and China) investment theme of the last few years had done extremely well and received an immense amount of attention from Wall Street and the media. But so far, 2008 has been especially cruel to China’s CSI 300 index – - down a whopping 54.23%. That compares to -27.4% India Bombay, -21.6% Russia, -13.6% Brazil and the USA down 11.95%.3 To anyone reading the last two lines and thinking that now might be a good time to “jump in”, please go back to the beginning of this article and remember that we are discussing investments here, not speculative bets.

In conclusion, China is an amazing country with an amazing history and no doubt an amazing future. China’s impact on the world in politics or economics is not in question here. What is debatable is the presence Chinese stocks should represent in your investment portfolio. I feel an appropriate analogy is to compare China to the internet. Both China and the internet have and will continue to change the world in which we live and invest. But just as the internet funds of the late 1990′s were too focused of an investment to be anything other than a bet, I believe the same is true of China-specific investments today. From my point of view, the prudent way to gain investment exposure to China is to not focus on the Chinese stock market. Instead, we should consider investing in a broader diversified investment such as an emerging market or international fund which includes ownership of Chinese equities preferably through stock markets outside of mainland China such as Hong Kong.

1 Data as of July 21st 2008, source Bloomberg

2 Data as of December 31st 2007, source Gene Fama Jr. Dimensional Fund Advisors

3 Data as of August 14th 2008, source Bloomberg