Investing in China: 5 rules of thumb

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My friends, who are rather dismissive of stock market commentary in general, give me no end of ribbing for the fact that I'm actually a stock market commentator. With that spirit in mind (a spirit of not taking myself too seriously), I'm going to start posting my thoughts on certain stocks, and the market, on a fairly regular basis now, because in general I do pretty good. 

 Today I just want to lay out a few of the rules of thumb I use when analyzing a stock. Most of them have to do with how to minimize risk in a fundamentally risky market, while keeping returns high. They are fairly simple, but I think that's their strength. We all realize now that most stock market types are too clever by half.

1. Don't trust the government - There are two points to be made here. First is that state-owned enterprises (SOEs) are bad investments. The most obvious reason is that SOEs operate to maintain social stability, not to maximize profit, therefore a minority shareholder in Petrochina is simply out of luck if oil prices rise too quickly. The less obvious reason is that performance at SOEs is measured by revenue, not profits. Which is just ridiculous, and can be a disaster for an expanding company. Most China-stock indexes are heavily weighted towards SOEs, which are a fairly low-risk low-return way of investing in "macro-china," but underperform the China market in general.

A related point is that large companies are often victims of regulatory shocks, which can give you a nasty surprise. This is one of the prime reasons people avoid investing in the Chinese market, as there is no real solution here except keeping a close watch on your stock, or diversifying.

You can game this system a bit, by investing in things that the government's self-interest implies high incentives for private sector involvement. This usually means utilities and commodities. Property too, but I wouldn't touch that with a 10 foot pole. 

2. Know "the big story" - in many markets you can look at returns, management, and say "well this company is better than its competitors. In China individual company investing are prone to the risks mentioned above, but "big story" investing can help you find areas of the market off the radar screens of both the government and investors, and these stories, more than anything, are driving the Chinese economy. Here are a few I tend to focus on:

A. Drastic expansion in the number of Internet users: Internet companies tend to be higher risk/higher return than others, because of censorship and all that. But there is no question that the Chinese Internet is among the biggest stories in the world anywhere at this point. My bets here (for the column, I personally invest in nothing) are Alibaba, because they are the only one with a sensible e-commerce solution, and Tencent, because they are the center of Chinese people's lives.

B. Growing demand for food, less space for growing: China has to push up yields, which means agritech.

C. Commodities: For obvious reason

D: Water shortage: I'm not great with this, but water treatment is on my radar, as I think its probably the biggest problem facing China.

I avoid China greentech, despite the fact I think its a big story. At this point there is far too much government involvement.

3. Small-caps are high risk, but very high return - The real strength of the Chinese economy is its SMEs. They are high risk - bosses tend to abscond with money occasionally - but the single biggest "big story" in China is the success of the Chinese private sector in boring manufacturing jobs, and its something that's difficult to invest in. 

I've recently become fascinated with this index fund as a way to cut down on the risk while keeping the returns. These guy watch this sector very closely, and while I disagree with some of their analysis (investing in gold?! what?) in general they're a good resource for those wanting to gamble a bit in an environment where the odds are against the house. 

4. Ignore Macro-tightening - I partially say this because my columns target a medium- to long-term investor. But I think even for short term investors, one shouldn't pay much attention to interest rates, reserve rates and all that. There are a few things going on here: 

First, interest rates in China don't mean the same thing as interest rates in the West. China's lending rate is capped at a level much much lower than demand for capital (which is why illegal banks can charge up to 30% interest). Interest rates mostly cut down on capital in the system through increasing deposits. Though, since the deposit rate is still often below inflation, it ends up being pretty meaningless. Western investors don't realize this, and end up overplaying the effect of an interest rate hike (it creates good buying opportunities). 

Second, the Chinese government is going to target 8% growth no matter what, and it will reach it, or exceed it. There's a question of how much the growth will be state-led, but the government will pick growth over inflation fighting any time.

Third, its much better to invest in China over the medium to long term. So what the hell are you doing watching interest rates so closely.

5. Chinese investors are bubble crazy - Mostly what I'm talking about here is property, though areas with heavy Chinese investments tend to be very very volatile so I thought I'd add in the lot of them. WIth property, despite the fact that Urbanization is one of the biggest of the big stories (China's urbanization level is the same as the US in 1919) there is a slew of technical reasons why investing in the property sector here is fraught with risk. Just say no.

I feel I should write a sixth titled "Watch out for armageddon," but that's a post for another time.