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Discount Factor Rises For Chinese Stocks

|Includes: Apple Inc. (AAPL), BABA, BIDU, CALI, CHU, CNIT-OLD, CYOU, GDS, IQ, JKS, LGEAF, SINA, SMI, SNP, SSNLF, VNET, WB, ZTCOF
Summary

ZTE Corporation is part of China’s spy network.

ZTE has become a bargaining chip in the trade war.

Each Chinese Company has Inherent “Espionage Risk”.

"Espionage Risk" results in higher discount rate in valuation calculations.

ZTE Corp., the fourth-largest seller of phones in the U.S., according to the research firm IDC, behind Apple Inc., Samsung Electronics Co. and LG Electronics Inc. has become a bargaining chip in the trade war between the U.S. and China. Investors therefore should not own ZTE Corp. shares (currently suspended), due to ongoing uncertainty and be wary of investing in other Chinese stocks as a result of increased discount factor.

ZTE and Huawei Technologies Co., equipment pose a national-security threat to the U.S.  Chinese government uses the tracking capability on the ZTE handsets to track U.S. military personnel, equipment and listen in on the conversations. The Pentagon has ordered retail outlets on US military bases to stop selling Huawei and ZTE phones and argued using the devices is a security risk. The Federal Communications Commission restricted the ability of U.S. carriers to buy Huawei and ZTE gear.

China’s predatory trade practices are based on strategic and military goals rather than pure economic considerations. China’s trade policy is part of its national security policy, heavily based on stealing U.S. secrets for both civilian and military purposes.

A survey of Chines trade policy reveals the following factors:

  • Government directs private companies’ investments.
  • Steals intellectual property from the U.S. and other countries.
  • Forces transfer of foreign technology as a condition of market access.
  • Economy is not a market economy.
  • Does not respect the rule of law.
  • Restricts exporting of rare earth metals.
  • Forces companies to manufacture in China.
  • Restricts foreign ownership.
  • Intervenes in financial markets.
  • Puts high tariffs on foreign companies, beneficial tax rates for domestic firms.
  • Forces long periods of share trading suspensions.
  • Subsidizes both public and private companies, i.e. export subsidies
  • Requires unfair licensing agreements.
  • Establishing its own technical standards in technology to sabotage the development and application of American technology.
  • Aggressively tries to purchase foreign technology firms in the US and elsewhere.
  • Retaliates against foreign companies if they complain about unfair and illegal Chinese treatment.
  • Uses its economic leverage to force foreign governments and companies to change their behavior, stalling Australian wine, U.S. cars and soybeans at the customs (increasing costs to foreign companies.)
  • Manipulates its currency to prevent natural trade adjustments.
  • Interferes in foreign elections by financing friendly candidates (Australian elections, and donations to Hillary campaigns.)
  • Violates and profits from international sanctions on other countries.
  • Conducts widespread cyber espionage, and all forms of spying – in 2016, more than 700 million Android smartphones were found to carry hidden software that enabled surveillance by tracking user’s movements and communications – software designed by Chinese Shanghai Adups Technology Company, whose customers include ZTE and Huawei
  • Installing spy software on smartphones (Lenovo, Huawei, and Xiaomi, ZTE).
  • Gathers information through the video cameras placed on the streets on all its citizens and foreigners.
  • Forces companies like CSCO, MSFT, JNPR to allow Chinese authorities access to their backend infrastructure. It is not only the U.S companies forced to transfer technology to China and manufacture in China. Japanese companies, Toyota, Hitachi, Showa Denko, have also been forced over the years.
  • Instructs the private companies to put patriotism first and forces a communist party agenda by setting up “party” units within the firms.
  • Takes partial ownership and management roles in private companies to further State’s espionage and control.

Chinese government has taken management roles and authority in corporate decisions. It has taken ownership stakes and exerts direct control over certain management decisions. The government calls it, “special management shares” and usually takes 2-3% equity stakes in the company.

This all clearly shows that Chines companies work hand in hand with the government for China’s aggressive military and strategic goals.  All the official policies listed above support the national military complex to dominate the world, and ZTE and other Chinese companies are part of this spy network, including firms such as VNET, BIDU, CSIQ, CYOU, CALI, CNIT, SNP, GDS, IQ, JKS, SINA, SMI, China Unicom, Tancent, Weibo, BABA, etc.

Since each Chinese company is part of the government’s spy network, each of them has an extra marginal risk above and beyond the “normal” political and legislative risk. I call this risk, “Chinese espionage” risk. Any China based company can become part of the trade war contagion at any moment. In valuing Chinese companies, the discount rate applied to such company should be much higher than the conventionally calculated weighted average cost of capital. The magnitude should be in the order of 10-20%, depending on the level of government ownership, and reliance on foreign suppliers, especially from the U.S.

Do you know if your next investment in a Chinese company not going to get entangled in the contagion, like the ZTE Corp.?

Sell ZTE and Chinese stocks that are part of the espionage network. Use the capital for less risky, more certain returns on other global stock markets.

Disclosure: I am/we are long AAPL.

Additional disclosure: I have NO position in any stocks mentioned, except in AAPL, and no plans to initiate any position within the next 72 hours and will not change my AAPL position within the next 72 hours.