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Beware of These Traits Before Investing in Chinese Companies

Background

China is a hot subject among investors thanks to its large market size and phenomenal economic growth. Intuitively, many would think of Chinese businesses as good investment targets. What could go wrong if the economic base grows at above 5%?

However, compared to the prosperity seen in places, such as shopping malls and restaurants, in China, the stock market may illustrate a totally different picture here. As described below, the S&P China ETF (GXC) significantly lagged the S&P 500 ETF (SPY) for the past 10 years.

Source: Yahoo Finance; data as of 7/30/2019.

While, admittedly, there exist decent opportunities in Chinese stocks, investors (especially those in the Western world) should consider certain characteristics regarding China-based companies before buying.

Diversification

Compared with their peers overseas, Chinese companies are more likely to try to diversify their businesses (when they have the chance to do so) instead of being laser-focused.

This is exemplified by many internet conglomerates. For example, Alibaba (BABA), originally an online retailer, established its fintech businesses to provide users with payment, banking, loan and insurance services a few years ago. So did its following rival, Tencent (HKSE:00700), originally a video game maker and a communication tool developer.

One explanation is that the ecosystem is changing rapidly in the country, pushing businesses leaders to make more bets (that may not be very relevant to what they are doing) in order to adapt. Another could be that traditional business culture in China (similar to Japan) would like to focus more on size than on efficiency. Hence, managers and investors often hope for a corporate empire to be built.

Theoretically, diversification should reduce risk, but this style usually favors management at the cost of investors. For example, returns on assets, equity and invested capital Alibaba have all been deteriorating consistently since their peaks in 2014, indicating less and less capital efficiency (see below).

Source: Morningstar; data as of 7/30/2019.

Competition and moat

Investing is mainly about: finding profitable and efficient business models and then figuring out competitive forces. I have no doubt about many wonderful businesses in China, but I would be wary of investing in them amid the fiercely competitive landscape here.

This is part of the reason Chinese businesses seldom have high returns on invested capital -- they would just have to invest more capital to fend off competitors, indicating very narrow or no moat. Ironically, one explanation for the extremely high competition may be too much entrepreneurial spirit. Per the United Nations standard, one out of every 10 Chinese people is an entrepreneur -- the highest concentration in the world. Having too many entrepreneurs, when surrounded by too much capital, is a potentially disruptive force to businesses already in the market.

The reverse is also true: Lack of entrepreneurship in countries like Japan can be a good thing to existing market leaders. Just think about Kakaku.com (TSE:2371), a Japanese life service tech company, which easily reached its return-on-invested-capital target of 40% year after year, versus its Chinese peer, Meituan-Dianping (HKSE:03690), which has struggled to make a profit since day one.

Those who are interested in reading more about the competitive tech sector in China can check out my previous article, Forget China Internet Companies: Right Models in a Wrong Market Destroy Value.

Cash is king

Investors' concerns mostly center on the trustworthiness of the financial numbers of Chinese companies (and I think they should). Therefore, cash flow instead of recognized revenue should be the focus when evaluating a business. Although this is obviously applicable to stocks in any country, I find such an approach particularly helpful in uncovering accounting risks with Chinese companies. For example, frequent higher operating income than operating cash flow or higher net income than free cash flow (as at Jupai Holdings (JP) and Noah Holdings (NOAH)) would alert me.

Channel check

Even after you trust the numbers, including cash flow, it is recommended to conduct channel checks when it comes to Chinese companies. This is especially valid if you are concerned about something like Muddy Waters' recent allegations against ANTA Sports (HKSE:02020).

In this regard, not only can investors talk to distributors but, if possible, to employees, suppliers, and end-users as well. I am not saying that there is fraud at ANTA Sports, but any investor who goes and checks the company's online and offline stores carefully should be able to obtain a better sense of the prosperity of the business (compared to purely reading its financial data and presentations).

Shareholder-friendliness

Chinese companies typically have relatively poor corporate governance structures compared to the Western standard. For example, it is often the case that the CEO shares the role of chairman of board or that there is a lack of independent (or non-executive) directors.

Additionally, investors may want to check the ownership structure of their company of interest to make sure that shareholder interests are aligned. State ownership in public companies is not rare but getting less common.

Summary

Investing in Chinese companies may pose challenges, especially to investors in the Western world, thanks to the characteristics described above. Some challenges may involve hard work, such as channel checks and due diligence. But, the good news here is that the solution to those challenges may be much easier than you thought: Stay within your circle of competence, invest in what you truly understand and make easy calls (on stocks).

If you have any memorable experience with Chinese stocks, feel free to share below.

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This article first appeared on GuruFocus.