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The lure of China remains, but bear in mind these are largely risky punts
By Jonathan Kwok
25 December 2011
Mention ‘S-chip’ and you are likely to send shivers down the spines of many an investor.
These Chinese companies have gone from being the darlings of the local stock market in 2006 and 2007 to being sullied by a seemingly never-ending series of corporate and accounting scandals and issues.
In the past week alone, scandal-hit Hongwei Technologies said it had appointed provisional liquidators in a desperate attempt to safeguard its assets.
There was also a saga at China Sky Chemical Fibre over the issue of appointing special auditors.
Amid the souring public perception of S-chips, those who have lost money cursed their bad luck while many others vowed never to touch these China plays again.
But are S-chips such a bad deal? Is there still a case for having them in your portfolio?
There is little denying that Chinese companies will benefit from the country’s economic expansion. Though China will not be fully sheltered from global storms, its growth will remain faster than Western economies’.
Valuations of S-chips have also fallen, meaning they can be regarded by some to be ‘cheap’. The price-earnings ratio of some counters can reach as low as under two - a very low valuation, though some local small-caps also offer similar valuations.
But that does not detract from the corporate governance issues of S-chips, and whether one can still have confidence in their reported numbers after the spate of accounting scandals.
Slightly less than 10 per cent of the about 150 S-chips are suspended due to governance or accounting issues, but this leaves out those that had been delisted or that needed to be saved by a white knight.
Even large firms like China Hongxing Sports, which at its peak had a market value of almost $4 billion, have been hit by scandal.
Among China companies listed elsewhere, Canada-listed timber giant Sino-Forest is an example of a large company accused of fraud.
In the course of my work I have had the chance to speak with many S-chip bosses. The first thing I have found is that many of them really seem like very decent people.
They argue passionately that they are honest businessmen, and that only a small handful of other firms are sullying their name.
However, over the past few years, even firms with charismatic leaders, strong growth stories and apparently robust internal controls and finances have fallen prey to scandal, meaning that even investors who have done their homework have lost their cash.
Successful British fund manager Anthony Bolton recently told the Financial Times that when investing in China firms he faces the challenge of whether to believe what he is being told and whether the figures he is getting are real figures, adding that ‘the quality of the information that you’re getting is definitely an issue’.
When even professionals find it hard to discern whether the company in front of them is going to be the next big thing or the next suspended counter, it is not going to be an easy game for retail investors.
As the market turmoil drags down valuations across sectors, it is hard to blame investors who park their cash in less scandal-tainted sectors, such as local blue chips.
But some investors continue to keep faith with S-chips, citing China’s growth story and the low valuations of the stocks. If one chooses to do so, it is helpful to consider strategies for managing risk.
Mr. Bolton said he conducts research on the sectors the firms operate in, to see if the industry performance confirms their reported financials.
He cited a case where he sold shares in a Chinese firm that was reporting 30 per cent to 40 per cent sales growth but market research suggested a significantly lower figure.
There is also a need for diversification, to spread risks. A shareholder who recently bought stocks of an S-chip in agriculture said that ‘investors should selectively buy a basket of them’.
‘One or two may die on you, but hopefully you will make’ good money on some, added the investor, who declined to be named.
This investor, being a wealthy individual, flies to China, speaks to companies’ management and goes through their accounts ‘with a fine-toothed comb’, but still admits the difficulty of discerning whether troubles will erupt at a particular firm.
‘I still can be misled,’ he said. ‘I still see a future in certain S-chips but I protect myself by going for companies with visible assets, as opposed to just numbers on a balance sheet.’
He invests in property companies as he can see their physical office buildings or shopping malls, but shies away from manufacturing, retail or service companies due to his scepticism over their reported sales, bank balances and inventory numbers.
Another important piece of advice: In the light of the risks of S-chips, investors should bet only money that they can afford to lose or take heavy losses on.
The sector should be assessed as a more risky play compared with, say, local blue chips. The investor calls it ‘just a part of my portfolio that I am willing to risk... I consider them more high-risk than hedge funds’.
This is a sector where you should be ready to do your research and manage your risks. Even so, especially for smaller S-chips, this may just be a game of putting in the cash that you can afford to lose, hoping that you will be rewarded very handsomely in time to come, if the firms’ valuations and earnings rise.
i still believe there are good chinese companies just like there are good people in China.
i do agree that we need to diversify, but not blindly and excessively.
J. Jacob
http://sharing-investing.blogspot.com/