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The Worst way to buy a share of China’s Rebound

By Jim Trippon

Regular readers of the China Stock Digest are well aware that China and the United States are headed in exactly the opposite direction. While the U.S. economy shrinks dramatically, China’s economy continues to expand. That makes China an obvious place to invest, but how?

The trend among many investors has been to pick an Exchange Traded Fund, better known as an ETF. According to ETF fans, that’s the best way to buy a position in any given sector without having to become a stock picker. The alternative is to buy a mutual fund, but most mutual funds charge high fees and often produce subpar returns.

ETF investing sounds good in theory but it’s exactly the wrong way to invest in China. Let’s take a look at the most popular China ETF, the iShares FTSE/Xinhua China 25 Index (FXI). The FXI Index is supposed to represent the performance of the largest companies in China. FXI consists of 25 of the largest and most liquid Chinese companies. Stocks in the FXI are weighted based on the total market value of their shares, so that securities with higher total market values have a higher representation in the Index. Sounds impressive, doesn’t it?

Well, not so fast. You would think that buying a basket of China’s largest companies should give you some protection against the wild swings of small cap stocks, wouldn’t you? No so. The FXI Index lost approximately 50% of its value last year even though China’s economy was expanding at a rate of almost 10%. How is that possible?

Let’s take a closer look at what goes into the FXI index. The biggest companies in China belong to a class familiar to China Stock Digest readers. They’re called State Owned Enterprises or SOEs. The problem with any State Owned Enterprise is that it may be a publicly-traded stock, but it is majority-owned by the government of China. In some cases, state ownership may exceed 85%. It’s not hard to guess whether politics or shareholder interests take priority when times get tough.

Consider the problem of one FXI component: China Petroleum & Chemical, better known as Sinopec (SNP). Sinopec is the largest petrochemical refiner in China with real equity valued at $300 billion.

But Sinopec shares lost well in excess of 50% of their value over the past year and the company is selling far below book value with a market cap of only $47 billion. The problem goes back to Sinopec’s state ownership and control. When international oil prices spiked last June, Sinopec was slapped with a nationwide price freeze on many of its refined fuel products. Profits were off 50% for the year even though fuel consumption was increasing. During the worst months of the oil price boom, Sinopec was actually subsidizing consumers and losing money on every gallon of gas it sold.

Another FXI component, Huaneng Power (HNP), one of the largest electricity producers in China, is also hemorrhaging money. Huaneng faces strict ceilings on its electricity prices because the government wishes to pacify hundreds of millions of consumers. Unfortunately, coal prices have skyrocketed and Huaneng has no choice but to pay the bill. The company has just reported that it will show a huge loss for 2008 even though it continues to build new, money-losing coal-fired generating stations. Share prices have undergone double-digit declines.

Another SOE, China Life Insurance (LFC) suffered a decline in share prices of more than 35% over the past year.  The company says its profits for 2008 may fall more than 50% because of a significant drop in its returns from its equity investments. Company watchers know that China Life was mandated by the government to invest heavily in the stock market in hopes of stabilizing wild speculation on the Shanghai Stock Market. In other words, China Life took a hit partly in service of Beijing’s mandarins.

Many China-focused mutual funds suffer from the same problem. They tend to invest in the large cap SOEs. Mutual funds and index funds usually stay fully invested even when the entire market takes a downturn. The China Stock Digest advises subscribers to get out of the market entirely when a bearish trend threatens to take all stocks down.

Jim Trippon,
China Stock Digest Editor-in-chief

We’ll have more on the right way to invest in China and the outlook for SOEs in 2009 in the upcoming issue of the China Stock Digest. February's Issue of China Stock Digest had the latest Stocks to buy and an extensive watch list of China stocks that are ready to bring big profits in 2009. To learn more about the profits to be made in China, please visit the link to subscribe: http://www.chinastockdigest.com/Page.php?Category=risk-free-subscription

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