China on the Rebound? How to Capture Upside and Sidestep Trouble
China seems to be coming out of its economic slump, and visions of that country once again providing fast growth in a plodding world have fueled a bit of a rush on Chinese equity funds. But there’s still plenty to worry about when investing in Chinese stocks.
For one thing, many Chinese companies are simply not doing well. The vast majority of Chinese companies reporting third quarter earnings so far gave weak or disappointing results, including Tencent Holdings, China Life Insurance (LFC) and PetroChina (PTR); three companies that represent big holdings in most major China ETFs. Direct investors in the Chinese stock market still take a rather grim view of corporate futures there. The Shanghai Composite Index is down about 15% in the past six months and still trades very near its lowest post-recession levels.
In fairness, we should note that a couple of big bank holdings in most China ETFs did well last quarter. But Chinese banks may be a particular problem for investors. A recent Reuters analysis shows that debt in Chinese companies is rising as banks there extend more credit, sometimes in questionable circumstances. Investors have little insight into lending practices, and the figures Chinese banks produce for underperforming loans are widely dismissed as ridiculously low.
Also, sketchy accounting should remain a concern for investors. Accounting scandals took down numerous Chinese companies and even the savviest of their U.S. investors in recent years. Remember John Paulson’s $500 million loss in Sino-Forest? Plenty of major fund managers lost money by betting on numbers in Chinese company books that proved to be fictional. U.S. and Chinese authorities are working on a joint audit program that might stave off accounting fraud, but it’s not in place yet.
China appeals to investors now because they see signs of an economic turnaround there. China’s GDP growth rate rose recently after seven straight quarters of slowing and likely will end 2012 up some 7.5% or more. It’s a beautiful figure against digits that barely break 1 or 2 in the U.S. or European countries. But keep in mind that China needs these faster gains to add enough jobs to continue a middle class expansion. It’s this evolution from few in the middle to many that’s boosted revenues in recent years for both Chinese companies and U.S. corporations -- sales of internet connections, smartphones and fried chicken, for example. Maintaining sales growth for these products depends on a growing class of people with sufficient disposable household income. China averaged annual GDP growth of about 10% for the previous decade before the recent downturn.
The turn in GDP generally, paired with recent signs that manufacturing specifically is improving in China, have led many investors to China ETFs lately, including SPDR S&P China ETF (GXC), iShares FTSE/Xinhua 25 Index Fund (FXI) and Guggenheim China Small Cap Index ETF (HAO).
Investing in an ETF is one of the safest ways to bet on economic growth in a foreign economy. Just remember that big GDP numbers don’t necessarily mean big investor returns. Real GDP growth in the U.S. ranged from negative 8.9% to a positive 4.10% in the quarters since the fourth quarter of 2007, and it certainly hasn’t been steady progress. That performance looks perfectly horrible next to China’s record. But you probably would have made more money investing here.
Dee Gill is a contributing editor at YCharts, which includes the just-released YCharts Pro Platinum for professional investors.