China's Fabulous Moolah

China's historic bull market run-up probably has further to climb, but investors should use extreme caution before making a foray into Chinese equities.

Story Highlights:

  • The dynamics of the Chinese economy and stock markets remain treacherous for foreign investors.
  • Yet, China's bull market rolls on. PetroChina became the first trillion dollar company by market capitalization as Chinese stocks continue their impressive run.
  • China's bull market probably isn't over yet, but tread lightly.

We in the investing world all love moolah. We think moolah is fabulous, actually. So we were saddened to learn the first lady of professional wrestling, the Fabulous Moolah, has passed to that great wrestling ring in the sky.

'Fabulous Moolah' of Women's Wrestling Fame Dies at 84

Speaking of Fabulous Moolah, how about all the moolah investors are making in Chinese stocks these days? (How was that for a segue?) Is the Chinese bull market set for a similar demise, or will it continue?

For a globalized, well-diversified portfolio of stocks, not owning any Chinese stocks (even during this huge bull market run) wouldn't hurt you much (it's not a very large weight in most global stock indexes). But a huge overweight to China could if things fall apart.

One of the little-known perils of Emerging Markets investing is the "free float" factor. A company's free float is the amount of shares available to the public on open markets. In many foreign lands a lot of stock isn't available to the public. Often the government or some rich family will own the largest share of stock (this portion, obviously, is not free floated). This can distort valuations mightily. For instance:

PetroChina's Value Tops $1 Trillion, Surpassing Exxon
Ying Lou, Bloomberg

This is a truly impressive public offering…a trillion bucks! Too bad it's completely bogus. For one thing, this isn't a true IPO—PetroChina has traded on the Hong Kong exchange with a market cap of around $73 billion for quite some time (86% of non-floated shares are government-owned). What actually happened today was an IPO of only 2.2% of PetroChina shares on the Shanghai exchange, coming to about $9 bn in capital raised.

Chinese stocks have all sorts of types of shares traded on differing markets with differing restrictions to differing folks. (Yeah, it's complicated.) The media got a tad excited and multiplied only the price of the Shanghai shares (a very small portion of overall share count which trade at a much higher price than the Hong Kong shares) to all outstanding shares—a calculation that has no basis in reality.

PetroChina is a big company to be sure, but in many ways much smaller than Exxon, for example. PetroChina's revenue is 25% that of Exxon's (about $91.9 bn vs $365.5 bn) and its refining activities don't even turn a profit due to current price controls imposed by the government!

All this is distorted by China's complicated capital markets structure and high government ownership. Large government ownership is not necessarily a bad thing, but it often is, and should absolutely be on investors' radar.

Sometimes a government's presence can add stability and confidence in a company, but just as often it wreaks havoc. Contrary to the spreading belief China has suddenly become a free market economy, it's still very much commanded by the government at almost every level. Thus, its whim can determine the fate of company profits and stock prices.

China is currently slogging through an energy crunch, facing huge gasoline shortages because its government kept prices artificially low for an extended period. Chinese oil refiners can barely break even despite the huge demand for gasoline! Finally, officials capitulated and raised prices 10% last week, but a huge economic distortion remains.

The same is true for inflation and currency: Beijing's policy of pegging the yuan (China's currency) loosely to the US dollar has created all sorts of havoc with trade policies and inflation rates. Though Chinese officials have raised interest rates in a bid to curtail an overheated economy, inflation continues to surge. Basic food prices in China are gaining at double-digit rates.

Couple that with underdevelopment (much of China is still rural), no stable financial system or capital markets, and murky corporate reporting, and you've got a recipe for trouble.

What's the common thread behind all these issues? The government. Based on whatever rules Beijing officials decide upon (and really, the rules seem to be changing daily), more or less foreign investment is allowed, trade tariffs are imposed or lifted, restrictions or openings on investment are made, and so on.

If the Chinese government decides on some wonky policy…say they decide foreigners should no longer be allowed to buy or own Chinese stocks (not at all impossible), it could send Chinese shares plummeting.

There's almost no question China's incredible stock run is a mania. But the key about manias is to know when to ride the run up and when to get out. There still seems to be some healthy skepticism about China and Asian markets in general, which suggests to us the Chinese bull market has further to climb.

But for prudent, long term investors, there are far too many perils to take a large portfolio weight in China. At best, maintain a market-weighting in Chinese stocks and perhaps try to capitalize on its robust growth through multinational countries set to make big profits by doing business in/with China.

There's still Fabulous Moolah to be made in China, but tread lightly before the title reign ends.

Source: Thomson Datastream, GaveKal

Also, for those truly interested in Fabulous Moolah (the wrestler), here's a biography of her storied career:

By Steve Slagle, The Wrestling Museum

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*The content contained in this article represents only the opinions and viewpoints of the Fisher Investments editorial staff.