With a population of 1.36 billion citizens, the fastest growing economy in the world and a middle class whose goal is to own an iPhone, a car and a home, China and its domestic stock markets represent an appealing if elusive investment opportunity. It’s one that’s now possible thanks to China’s new Shanghai-Hong Kong Stock Connect program.
The program opened up China’s domestic stock markets to international investors for the first time ever this week. Investors will have to go through brokers in Hong Kong, who often charge high fees, but previously, only approved institutional investors, who control millions or billions of dollars, had been able to buy China’s domestic shares.
The move is a major milestone in China’s slow embrace of Western-style capitalism – “trying to open their financial system to the world”, as Paul Christopher, chief international strategist at Wells Fargo, puts it.
“It is a major breakthrough for them. The government is committed to making major reforms, including speeding up currency reform and improving access to the Chinese stock market,” said John Krey, international investment analyst at S&P Investment Advisory Services LLC.
Still, there are plenty of signs to suggest US investors should slow down and do their research before jumping into Chinese investments, particularly now.
One barrier: China’s companies are characterized by a lack of transparency to the West and an absence of legal protections. Analysts warn that accounting and disclosure standards in China don’t match up to more rigorous western standards.
“In the US you’ve got access to SEC filings when you want to learn about a company. It is not as easy to find compliance and disclosure statements for Chinese companies,” said Patrick O’Hare, chief market analyst at Briefing.com.
Nor are US investors likely to get much of a voice in Chinese companies. A good recent example is e-commerce giant Alibaba, which solicited the investments of American stock-pickers in its initial public offering – but declined to give them any voice in running the company. Instead, Alibaba concentrated all decisions in the hands of a 28-person partnership.
Those companies less recognizable or established than Alibaba may prove problematic to US investors. “What’s the first thing a struggling business will do? Look to get more investors,” noted James Pressler, vice president at The Northern Trust Company.
All of this telegraphs risk, at least until the kinks are worked out.
“Stock Connect opens up new opportunities and it is forward thinking, but it is still untested. There are obviously safer and more conservative ways to invest in China than going in and trying to pick out winners on the Shanghai exchange – that is hard enough to do here in the US,” O’Hare said.
Case in point: billionaire hedge fund manager John Paulson reportedly lost $468m in Chinese forestry company Sino-Forest Corp (TRE) in 2011. The losses triggered questions regarding the accuracy of the accounting of the forest and timber land holdings.
“John Paulson is generally considered to be one of the most successful hedge fund managers, yet he lost a fortune in Sino Forest. If even he can get hosed in China, what hope does the individual investor have?” said Charles Sizemore, principal of Sizemore Capital Management.
Basic research could be a challenge.
“The US has a well laid out GAAP (generally accepted accounting principles). In China, things are less transparent. They don’t have the same accounting standards,” said Briefing.com’s O’Hare.
“You are at the mercy of the company giving you the numbers,” said Sizemore.
The China real-estate bubble
The Chinese government is also trying to gently deflate a real-estate bubble that inflated after the government pumped out a stimulus package worth $583bn, noted Northern Trust’s Pressler. “It did the job of triggering growth, but it also fueled real-estate speculation, similar to what was going on in the mid-2000s here.”
Slowing economic growth may be another concern. In the early 2000s, China boasted a rapidly growing economy, which peaked in 2007 with above 14% growth.
Now, most economists agree China’s double-digit growth is in the rearview, with 2015 forecasts in the range of 7% or even lower. While that still outpaces the growth of the US economy, China’s trend line is dipping downward, not upward.
Pressler suggested the new program may mean the Chinese think “we are safe enough and we don’t have to worry about significant amounts” of money leaving the country.
China’s politics
“China is still a communist country. They have adopted some free-market principles, but some of the companies are state-owned enterprises. Investors run the risk of seeing their interests being subordinated to the government’s interests,” O’Hare explained. “The government has the ability to changes the rules of the game arbitrarily as an individual shareholder is on the outside looking in.”
Bill Smead, CEO and CIO of Smead Capital Management, weighed in. “It is a totalitarian communist government that practices capitalism. You have to be skeptical about investing in a country where the legal structure could render your ownership as moot at any time,” Smead said.
Investors looking for recourse won’t have the same options as in western countries.
“The Chinese courts are not courts in the way we understand them. Chinese law is a guideline for the judges,” Northern Trust’s Pressler said.
“They don’t have a court system where you could go sue if something goes wrong,” said S&P Investment Advisory Service’s Krey.
Currency risk is another factor. Not only are investors purchasing shares in a Chinese company, they are also placing a currency bet. The US dollar has been on a tear in 2014, climbing broadly versus major world currencies. The US dollar index is up over 9% year-to-date, while the dollar has gained 1.2% versus the managed Chinese yuan rate.
Intent on diving in anyway? Set your alarm: there is a 13-hour time difference between New York and Hong Kong.
“If you have a position you want to do something with, you might not get a lot of sleep that night,” noted O’Hare.
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