February 04. 2013 9:00AM

China's stock market is a risky bet

Dispatches from China

By Einar Tangen

  
Investing is a calculated risk vs. return wager. It is not a guarantee.

In the United States and Europe, we assume that between the regulators, underwriters, rating agencies, lawyers, accountants and the massive 10-percent deal fees that we can rely on certain types of information when a stock is launched.

As many of us have found out, the system is less than foolproof. So what does it mean when you place your bet on a firm, which does business in China, a country that has had a functioning capitalist market for less than 25 years?

The sum and substance of this column is, when doing business overseas, trust nothing and verify everything. If you cannot, or choose not to, you have decided to take the risk.

Let's add it up:
  • Weekly, widely publicized, stories about Chinese accounting irregularities.
  • Immature banking, finance and regulatory infrastructure.
  • A competitive market, which rewards creative business practices.
  • Rarely disclosed complex interwoven business and personal relationships
  • Flexible consultants, lawyers and accountants, who may be more interested in fees than the situation.
  • Rapid localizing initiatives that replace high-priced international talent and experience with lower priced less experienced local resources.
  • Getting a valuation on a foreign bourse, which puts your company's value at 14 times earnings.
  • 5,000 miles and no extradition treaty,

If your answer is, "It does not look good," then we agree.

So how do you get a piece of what you think is going to happen in China if you are sitting at your desk in the United States? Answer: It is probably not a good idea. Unless you wish to move to China, spend time learning the language, the culture, government system and make friends who you can absolutely trust, the percentages are against you.

But, given you are stubborn and think that there are great big gold bars with your name on them in China and it's time to collect, you have two basic choices. Invest in foreign firms that you think will do well in China or invest in Chinese firms that you think have a viable business model and ability to execute.

If you like the feeling of a familiar tried-and-true brand which you think is going to take the Chinese market by storm, there are a few things you should think about. Why do you think success in the West equals success in China? Remember tastes and cultures differ. Does the firm you have in mind have the experience and expertise to make this kind of move? Check the history of the management team. How much experience do they have in this kind of endeavor? What is their market entry strategy? If they are relying on Boston Consulting, Booze Allen or the other consulting groups, you may want to run, not walk away. This is not an attack on the consulting industry. The point is if you do not have your own ideas about how you intend to enter a complicated, volatile, highly competitive market like China, then you are not the person or group who should be leading the charge. If corporate is not clear on the strengths, weaknesses, opportunities and challenges on day one, it is not going to go well when reality hits the fan.

Even if they get through market entry, you have to constantly evaluate the direction of the company. For example, Yum Brands, which until a week ago had burnished their reputation as a Chinese market innovator and executor, stumbled on reports of too many steroids in their chicken. My guess was rapid expansion pressures caused them to turn a blind eye, on what had been the centerpiece of their Chinese corporate model: supply chain quality and logistics.

It's going to cost Yum 4 percent of their sales in their largest profit market. It makes you wonder if the foreign managers understand that, unlike the United States, where bad food, medicine or baby formula is a white-collar slap on the wrist, in China, if people die because of something your company did, people from your company could die as well.

The second alternative is to invest in a Chinese company that you think is going to make the world stand up and take notice. Huawei is a leading global information and communications technology (ICT) solutions provider, which, despite constant blacklisting, has taken over markets once owned by Cisco and Ericsson. In 1988, the founder started with 21,000 RMB ($2,100 U.S. dollars at 1987 exchange rates). In 2010, it became a Global 500 firm. Every year, they pour billions into R&D centers located around the world, file thousands of patents for leading edge technology and count 50 of the 54 largest telecoms as their clients. Sounds perfect. Except, there's one problem. You cannot buy shares, as it appears to be privately held. But like many things in China, it is hard to know the exact situation. Are there other companies? Yes, but as I said, it is hard to know what the situation really is, so verification is difficult at best.

So what am I saying? Go back to the mantra, if you cannot verify, do not get involved. China will continue to be a place of interest economically, but investing in China stocks is at best a crapshoot. In five to ten years, things may change, but in the meantime, if you feel the need, the safest bet is doing it directly in a business you understand, after you have a very good idea of the things you need to know and do.

If it's any consolation to those who have already lost money, what holds true for you is also true for Chinese investors, who have also lost hundreds of millions. The government is taking a harder line on these situations, as concern grows about the state of China's equity markets. But the response will be at best slow, as they are hampered by an immature regulatory system and a lack of trained staff.

That's all for now. Welcome to 2013.

Einar Tangen, formerly from Milwaukee, now lives and works in Beijing, China. He is an adviser to Heilongjiang Province, Hebei Province QEDTZ, China.org.cn, China International Publishing Group, Beijing Baotong and DGI DESIGN. He is also a weekly public affairs commentator for CCTV News' Dialogue and the author of "The Kunshan Way," an economic development history of China's leading county level city. While in Milwaukee, he was a partner at Jackson, Morgan and Tangen, president of E-Tech and a senior vice president at Stifel Nicolaus. He chaired various boards in Milwaukee and was a member of the Federal Home Loan Bank of Chicago. Readers who would like to submit questions or suggest areas of interest can send an e-mail to steve.jagler@biztimes.com.

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