Living4Dividends'  Instablog

I'm a big fan of emerging market equities. Naturally, I have studied China because China puts the “C” in BRIC.

What's Not To Like About China?

• China is financially strong: with one of the world’s highest savings rates, and large foreign currency reserves.
• China is fervently pro-growth. The Chinese economy has been the one of the fastest growers over the past decade.
• China has an abundant supply of cheap labor. It is pro-industry to the detriment of labor.
• China is not hampered by costly environmental or worker safety regulations.
• To promote exports, China has kept the Yuan low.

I’m Sure That Even The Price Of Tea Is Controlled
Derek Scissors, writing in a recent issue of Foreign Affairs in the article “Deng Undone”, documents how nearly everything is tightly controlled from the price of grain to the price of electricity:

Price liberalization, the core of market reform, has been partly undone. Privatization was stalled at first and then explicitly reversed. Initiatives to increase corporate competition are also being rolled back. The Chinese state is increasingly encroaching on even the relatively open external sector by restricting incoming investments and imposing taxes on exports.

The central government has recently reversed the outstanding progress in the liberalization of prices that China made during the first two decades of reform. The price of labor (wages) remains largely free from government interference, but that is manifestly not the case with the price of capital (the interest rate), for which the People’s Bank of China sets a compulsory and narrow range. Government intervention constantly distorts the prices of basic assets, such as land, often by simply forbidding or promoting transactions. The State Council sets and resets the prices for all key services: utilities and health care, education and transportation. Although the exchange rate has been loosened up over the past three years, the People’s Bank of China sets the daily value at which the Yuan must be traded against the dollar. And currency fluctuation is still starkly limited: the daily movement of the Yuan against the dollar is not allowed to exceed 0.5 percent. The market in China has never really determined the sale prices of many ordinary goods by itself, and the tendency over the past few years has been to further extend price controls for goods. The state’s complete control over grain distribution has distorted wholesale grain prices; a recent bout of inflation has prompted restrictions on the prices of retail food as well.

High Dividend Yield Chinese Equities
I like the idea of high dividend yield Chinese stocks. Consider Huaneng Power (HNP), a large, boring electric utility. Over a year ago Huaneng Power had electrifying prospects, with a shocking dividend. Its balance sheet was charged with plenty of profits, easily supporting its then current dividend yield, north of 6%. Certainly not a stock with high-voltage potential, but a profitable electrical utility growing as fast as the Chinese economy.

When coal prices rose, and the downturn hit, Huaneng was zapped with a calamity. To stay profitable, it needed to raise its electricity prices. Because higher electricity prices are detrimental to the economy in a downturn, the regulators blocked the rate increase. Huaneng announced a dividend cut to 2%. I promptly discharged the majority of my position. I got out when the getting was good.

China’s Market Cap Is Dominated By:

• State-Owned Companies
• State-Controlled Companies
• Highly Speculative Companies

State-Owned Chinese Companies:
In a recent article, Seeking Alpha author William Gamble, bashes the capitalization-rich Chinese State-Owned Companies:

My advice is to never buy stock in a state owned company.  …. Why wouldn’t you want to own shares in the Industrial and Commercial Bank of China (HKG 1398 SHA 601398), the world’s biggest bank? The world’s largest telecom operator is China Mobile (CHL), in one of the world’s fastest growing market. Who would not want the safety of a telephone company in a dynamic market? The combination of oil and China seems irresistible, especially for an investor in PetroChina (PTR). … There is no life insurer anywhere larger than China Life. …

Even worse, sometimes for reasons only known to the government, entire sectors or managers can be reorganized and not for the benefit of minority shareholders. In 2008 the entire Chinese telecommunications industry was reorganized. The three firms, China Mobile, China Telecom (CHA), China Unicom (CHU), swapped operations and merged with smaller carriers. It was China’s fourth reorganization. Also in China, round robins of executives in different companies in the same industry are not uncommon. In 2004, China’s three top telecommunications providers, China Mobile, China Unicom and China Telecom, all swapped senior managers. Among China’s airlines, China Eastern Airlines (CEA) got the Chairman of China Southern Airlines (ZNH). China Eastern also received a new president from Air China. The old president went to Air China as deputy president. Since many of the managers of state owned corporations are or will be bureaucrats, it may make little difference. The president of Chinalco (ACH), Xiao Yaqing, was kicked upstairs to become named vice secretary general of the State Council, China’s cabinet.

State-Controlled Chinese Companies:
As Derek Scissors points out: much of the economy is State-Controlled.

Highly Speculative Chinese Companies:
Chinese Herbal Medicines?  Not suitable for this prudent investor.

Great Story, Risky Investment
Heed well Derek Scissor’s and William Gamble’s negative comments about the "Free Market" in China. It is difficult to make a profit in a tightly controlled economy. I still hold a small amount of HNP.  I don’t invest in BRIC anymore, now I invest in BRIc. 

China gets a lowercase “c”.  

FULL DISCLOSURE: Author is long a small amount of HNP and Chinese indexed instruments. You should consult with a professional before investing.