I reckon I've come up with a great way to make money: Short Chinese shares. Here's the deal - in my humble opinion most Chinese companies quoted on the UK and the US markets make a lousy investment. I realise this may come as a bit of a shock from someone who has written at great length about emerging markets but I'm afraid that I've had an epiphany - an awful revelation - based on too many bad investments within my own Sipp.
So here is the gist of my experience, which has shaped the argument above:
China at all costs
Many foreign (British included) suddenly develop a dangerous obsession with all things Chinese and decide that they really need to invest in China somehow or another. Take one of my investments - Epay. This seemed to be a well-run Malaysian company going places until, well, it got somewhere which was China. It tried to crack China and guess what happened - China cracked it. It suddenly ran into fairly unspecified problems, lost a fortune and the shares crashed from just shy of 20p to a measly 3.5p. The moral of the story - unless you're a giant mega-cap with the muscle say of HSBC your chances as a measly UK small cap of breaking into China are not to non-existent.
Small caps: same the world over
One of the great myths of the modern era is that China is full of amazing little gems run by spirited, feisty managers and entrepreneurs who can build a niche in a massive market. If you take this idea and multiply it across literally dozens of sub-sectors you have the stuff of private equity/venture capital wet dreams. Or so at least London Asia Capital reckoned when it decided to build a niche in investments in the micro-cap and pre-IPO sector. The business model sounds great. Employ lots of bright young things from parts Eastern, get them to research new companies, introduce them to the London market, and also invest in the companies through a separate closed end venture capital fund. What went wrong? The shares have now crashed from around 10p to 5p in less than a few weeks. Quite what has actually caused this calamitous slump is beyond me but I suspect that a) lots of options were issued forming an over-hang b) lots of institutional investors have grown weary of small Chinese private companies constantly disappointing (think Prosperity and Renesola) and c) a general flight from risk in the small cap arena
The dead hand of the state
One of my other awful investments has been in Chinese company Hurray which looked to be about to carve out a great niche in value added services to the mobile phone industry. The Chinese you see are big on texting and mobile phone games and as GPRS and 3G makes an impact; companies like Hurray should be able to move more punters onto next generation game platforms that involve say gambling and heavy interactivity. It's the same lure that attracted Monstermob to monstrously overpay for a clutch of companies in the same sector. The problem? The huge mobile phone giants and the Chinese regulator decided to call it a day, knee cap the nascent industry and take the profits back in house. And guess who owns most of the mobile giant's shares and who also runs the regulators - you guessed it, the all powerful communist State.
Race to the bottom
I allowed myself a sly smile when I heard that the Sage of Omaha himself, Warren Buffett, had started investing in China (an oil company apparently attracted his attention). My guess is that most Chinese companies would never, ever pass his stringent analytical value tests because beneath the hype about market growth, beneath the chat about huge opportunity, most private Chinese companies are simply playing the commodification game. Make it ever cheaper, undercut the enemy, and then hope your market position rescues you when the competition intensifies. The only problem is that all too frequently the competition moves quicker than you - especially as the cost of capital is so low in China - and your margin quickly crumbles following a price war. Cue a profits warning and the inevitable investor disappointment.
Add all these up, plus a few others - the poor quality of so many listed Chinese companies plus a strong element of insiderism as the families and management who control these companies manipulate them for their advantage, not the wider shareholder base - and you get a pretty broad damning indictment. In my considered opinion based on some hard experience these are by and large poorly managed, poorly capitalised companies in a shallow pool lacking in quality and hindered by an oppressive state with no real respect for the legal framework.
So, here's my gamble. I'm willing to bet that most of the star Chinese performers will under-perform and disappoint. If you're clever you'll make money from this by shorting the shares within the sector.
I have to of course add a couple of important caveats to this bearish take.
•One key proviso is that there are a very small number of high quality companies where shorting probably won't work (Asian Citrus and RC Group for instance look pretty decent).
•Also all the above is not to deny that China IS changing the world little by little - the rise of China is a seismic change and one that private investors can and will benefit from in lots of ways. It's just that I strongly believe the best way to play this great structural change is through a diversified closed end fund like London Asia's Chinese Private Equity fund or a unit trust managed by the likes of Templeton, Fidelity or Neptune.
