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I first invested in a Chinese company on October 15 2010. The catalysts for my investment were rather simple.

  1. China’s Growth - China’s GDP was growing on an average rate of 15.7% per year for the past 20 years, according to data compiled from the World Bank. In comparison, the US grew at 4.9% per year on average for the past 20 years. This (the 15.7% average growth) is of course unsustainable but based on analyst estimate of 9% GDP growth moving forward, China’s economy will double in the next 7.8 years as compared to the US economy, which will only double in the next 25 years based on a growth rate of 2.8% (based on the Rule of 70). Some economists predict that China’s GDP will be greater than the US by 2020. China's economy is the second largest in the world after that of the United States. China’s gross domestic product is worth 4,909 billion dollars, or 7.92% of the world economy, according to the World Bank. Don’t these ubiquitous stories in the most notable financial magazines just whet your investing appetite every time you read it? Don’t you just want to have a taste of that sweet nectar before all the suckers drink every last drop of it?
  2. Diversified Portfolio - I also wanted to diversify my portfolio across different countries and currencies. Why? The 2008 financial credit crisis and everything else that ensued seems to be affecting the developed world pretty badly. Think about it: Which countries are all over the news with downgrades and defaults right next to their country's name in every headline in every financial website, newspaper and magazine. Weren’t these countries the same ones that colonized all the developing countries, including my own not too long ago when my grandfather was still in grade school? Weren’t these countries all on your travel list? Weren’t they the ones with all the famed universities and academic dignitaries and famed philosophers? With a majority of the developed world in crisis, don’t you want to diversify your portfolio in a country with tremendous growth opportunities, a strengthening currency, a growing middle class and many infrastructure projects in place?

These two reasons propelled me to make the decision to research a few Chinese companies. There were a few industries that I thought would be a good addition to my portfolio: Pharmaceuticals, Technology, Food and Beverage, Clean Energy and etc.. However, my main goal was just to purchase a small cap Chinese company. Below were the companies that came to my attention

Returns as of 7/15/2011 1:45P.M.

Ticker

Market Cap

YTD Return

CNIT

122.4M

54.7%

CSR

471.94M

1.31%

OTCPK:YUII

24.5M

86.48%

CPHI

93.75M

28.71%

CAAS

225.51M

41.04%

MY

670M

52.96%

YONG

249.32M

39.76%

For the sake of comparison:

  • S&P 500 4.22%
  • Russell 3000 4.72%
  • DJIA 7.42%

The worst performer was Yuhe International, with a YTD return of -86.48%. The company, a supplier of day-old chicken raised for meat production, was sued after an analyst entered the market on June 16, 2011, quoting Dajiang's chairman that Yuhe did not acquire Dajiang's farms, as Yuhe had represented in its SEC filings and other public statements. The complaint asserts violations of the federal securities laws against Yuhe and its officers and directors for issuing false and misleading information to investors about the financial and business condition of the company. The complaint alleges that (a) Yuhe's financial results as reported to the SEC for the fiscal years ended 2009 and 2010 were materially false and misleading; (b) Yuhe lied to investors about its purported acquisition of 13 breeder farms from Weifangshi Dajiang Qiye Group Co. Ltd. ("Dajiang"); and (c) Yuhe's business was not growing at the rate represented by defendants.

The thing is, I almost invested in this company. I actually narrowed it down to CSR, CNIT, CPHI and YUII. At that time it made a lot of sense to invest in all these companies - the net income growth were in the double digits consistently, there were a lot of vertical integration acquisitions, relative valuations were extremely attractive compared to their peers in the same industry, backlogs continually increased, margins were high and increasing, growth projections and demand projections were high, growth strategies were sound and so on... So, the important question is, why haven’t the stock prices risen considering the attractiveness - or were they even attractive to begin with?

Things to Consider Before Investing in China or Other Emerging Market Companies

Valuation in emerging markets are drastically different from developed markets. There are many reasons for that, including financial statement reliability, accounting standards, debt tolerance, corruption etc., but the main concern would be the effect of inflation.

The distinction between real and nominal values is particularly important in emerging markets because those economies tend to experience high inflation rates. China's Consumer Price Index showed that prices rose 6.4% over the last 12 months ending in June, as China's National Bureau of Statistics reported Saturday. Compare this to the US’s inflation rate over the last 12 months; the all items index increased 3.6 percent before seasonal adjustment. China’s inflation rate is 77.8% higher than the US’s. The question is: What are the effects of inflation on financial statements stated in nominal terms?

  1. On the balance sheet inventory, plant, property and equipment (non-monetary items) may be shown at values well below their current cost. This means that assets may be overstated.
  2. In the income statement, depreciation charges will be well below replacement costs.

High inflation rates also affects ratios calculated from nominal financial statements in the following manner.

  1. Sales growth will be overstated.
  2. Fixed asset turnover will be overstated, as fixed assets do not capture inflation effects in a timely manner but sales do reflect effect of inflation.
  3. Operating margins will be overstated, as sales reflect inflation but depreciation does not.
  4. Return on invested capital (NOPLAT/invested capital) is typically overstated, as NOPLAT is overstated and invested capital is understated.
  5. Solvency ratios, such as debt to assets, will be too high as assets are understated.

There are many adjustments to the financials of an emerging market company’s financial statement that needs to take place before being able to appropriately value a Chinese company for recommendation.

For the average investor, I think a less painful way to have an exposure to China’s growth story is to invest in an ETF:

  • iShares FTSE/Xinhua China 25 Index Fund (NYSEARCA:FXI)
  • EGS INDXX China Infrastructure ETF (NYSEARCA:CHXX)
  • Global X China Consumer ETF (NYSEARCA:CHIQ)
  • Global X China Energy ETF (NYSEARCA:CHIE)
  • Global X China Financials ETF (NYSEARCA:CHIX)
  • Global X China Industrials ETF (NYSEARCA:CHII)
  • Global X China Materials ETF (NYSEARCA:CHIM)
  • Global X China Technology ETF (CHIB)
  • Guggenheim China Technology ETF (NYSEARCA:CQQQ)
  • Guggenheim/AlphaShares China All-Cap ETF (NYSEARCA:YAO)
  • Guggenheim/AlphaShares China Real Estate ETF (NYSEARCA:TAO)
  • Guggenheim/AlphaShares China Small Cap Index ETF (NYSEARCA:HAO)
  • iShares FTSE Hong Kong Listed China Index Fund (NASDAQ:FCHI)
  • Market Vectors China ETF (NYSEARCA:PEK)
  • MSCI China Small Cap Index Fund (NYSEARCA:ECNS)
  • Powershares Golden Dragon Halter USX China Portfolio Fund (NYSEARCA:PGJ)
  • ProShares Short FTSE/Xinhua China 25 Index ETF (NYSEARCA:YXI)
  • ProShares Ultra FTSE/Xinhua China 25 Index Fund (NYSEARCA:XPP)
  • ProShares UltraShort FTSE/Xinhua China 25 Fund (NYSEARCA:FXP)
  • SPDR S&P China ETF (NYSEARCA:GXC)

If you really want to invest in individual companies, I think it is safer to invest in large cap international chinese companies such as PetroChina (NYSE:PTR), China Southern Airlines Limited (NYSE:ZNH), and China Unicom Limited (NYSE:CHU). Happy investing!

Sources:

Disclaimer: I am a CFA level II candidate and these information represents my own opinion towards the subjects discussed.

Source: What to Consider Before Investing in China and Other Emerging Markets