This essay originally appeared at The DailyReckoning.
"When customers start demanding things, you know it's going to start topping out," says Arnold Van Den Berg, the 64-year-old founder of the eponymous money management firm that has soundly beaten the market averages since 1974. The investment business "is the only business where the customer could be wrong."
Investors have been clamoring for Chinese stocks like children pining for more dessert. But unlike dutiful parents, the market is giving them what they want - even though some of these companies are not quite ready for life as publicly traded companies.
Recently, I've written about how China was the "Big Story" and cautioned that China, as an emerging market, was likely to suffer some gut-wrenching peaks and valleys. It didn't take long for the market to provide a fresh example in the plight of China Aviation Oil (CAO), the monopoly provider of jet fuel to China.
China Aviation Oil collapsed after disclosing losses of $550 million stemming from oil derivatives trading. It was the biggest scandal to hit the Singapore exchange since rogue trader Nick Leeson felled the venerable Barings Bank. Worse, the state-owned parent company apparently knew about the losses before it sold a 15% stake in the company to unwary investors.
Is CAO a portent of things to come or just an aberration?
On the one hand, say some officials, this is something that could have happened anywhere. Indeed, it could have; trading losses in derivatives are not a uniquely Chinese occurrence. Corporate skullduggery is a universal pursuit. But when the CAO event happens in a larger pattern of fraud and deception, one has to wonder if CAO's problems are not isolated, but endemic.
"The company's troubles follow a string of embarrassing disclosures at big Chinese state enterprises," writes Peter Wonacott for The Wall Street Journal. He goes on to name recent troubles at China Life Insurance and BOC Hong Kong - victims of poor disclosures and corruption.
Disclosures are not the best in China. "It's very hard to figure out what's going on in these companies. They are a complete black box, maybe a black hole," says Fraser J.T. Howie, co-author of a book on the Chinese stock market and corporate reform.
Particularly galling for investors was the fact that CAO was widely regarded as exemplary of good governance. "It was feted by the local press as a model of corporate governance, and investors eagerly bought its shares," reports The Financial Times. CAO shares surged 215% from the start of 2003 to last Monday, when the scandal broke.
Popularity is like arsenic to healthy investment returns. In the case of China, its popularity is unquestioned, as foreigners have been pouring billions into Chinese state enterprises. A consensus has congealed around China - marking it as the hot investment nightclub of the town. But new research from China Economic Quarterly (CEQ) sheds some light on who is making money in China so far.
Joe Studwell, the editor-in-chief of CEQ, summarized the latest research in a column appearing in the Financial Times. He looks to answer the question of how individual companies are faring in the frontier of Chinese capitalism. To preview his conclusion, his answer is "not that great."
Studwell readily concedes that his conclusion "runs counter to the received wisdom about the abundant and lucrative opportunities for foreign companies in China." Given my interest in all things counter to received wisdom, I diligently read on.
The main point of the CEQ is that yes, profits from U.S. affiliates in China have been rising. In 1999, they were basically zero. By 2003, they were around $2.4 billion. CEQ estimates that counting total profits - including profits for U.S. affiliates as well as profits booked in Hong Kong and Singapore - and a variety of licensing and royalty fees, that number swells to about $8 billion in profit.
But lets give that some perspective. As Studwell points out, "In 2003, U.S. companies made $7.1 billion in Australia, a market of only 19 million. They earned $8.9 billion in Taiwan and South Korea, emerging economies with a combined population of 70 million." Studwell even points out that U.S. companies made $14 billion in Mexico, which, in his words, "is considered by many people to be something of an investment dud compared with China." Be we know otherwise.
The steadiest earners among U.S. companies in China have been American automakers and fast food chains. General Motors earned $437 million alone. Yum! Brands - with 1,200 restaurants in China - and McDonald's earned about $200 million. Together, these two sectors accounted for nearly one-third of total U.S earnings in China.
Moreover, these companies are achieving profit margins no better than their global averages. While this indicates a number of things, it is obvious that it is harder to make money in China than widely believed. The cost of doing business there is perhaps higher than advertised. By all accounts, China is still heavily regulated and deeply bureaucratic.
For some reason, commodity profits were not included in the survey. But as Studwell points out, the biggest beneficiary of increased Chinese demand for metals draws only 10% of its earnings from mainland China.
For all this, there is no denying that China is the workshop of the world - the cheapest manufacturer of many things on the planet. "The people who make the real money in such an economy," Studwell concludes, "are the ones who buy from it, rather than the ones who invest in it." China as supplier is an instant money saver.
Plus, China as a heavy consumer of commodities is undeniable. News on Chinese consumption of copper or coal can send those commodities rising or falling 10-15% in a matter of days. China holds more potential than perhaps any other market in the investment universe. "Potential" is the key word, however. Reality says something different - at least today. There will be more scandals and more disappointments, but there is a prize to be won in China. It simply may not be in buying Chinese stocks, and the profits may come more slowly than commonly thought.
The emergence of China as an economic power is not preordained. There is still much that has to happen before that becomes a reality. Today, China lingers in the foothills of prosperity, but the peaks - "the Alp at the end of the street," as poet Wallace Stevens wrote - loom beyond.
Regards,
