The China Bubble

At the height of the dot-com bubble in 1999, the magic word for hyping a stock was "Internet." Pets.com, one of many speculative dot-com companies, earned a gilded stock price of $11 per share in early 2000. Buoyed by an initial investment by Amazon.com, it ultimately raked in $300 million in early financing. Like many Internet companies in that era, however, it never earned a profit; when the bubble popped in late 2000, just months after Pets.com went public, the company announced its liquidation, driving shares down to 19 cents, a 98 percent loss. Today, the magic word for hyping stock could be "China."

A China strategy remains the holy grail for global companies. While China’s growth has slowed from over 10 percent just two years ago to 7.6 percent in the second quarter of this year, executives still make their China strategy prominent in pitches to analysts and investors. Thirty-seven percent of companies surveyed from a range of industries consider China "critical to global strategy," according to an Economist Intelligence Unit report from November that surveyed executives from 328 companies. Forty-six percent expect China to be their biggest market within 10 years.

The conventional wisdom is that multinationals that successfully build market share in the fast-growing Chinese market will deliver profits that reward investors handsomely. Indeed, the success stories can be astonishing: Yum! Brands, which operates over 3,800 KFC restaurants in China and claims a 40 percent share of the fast-food market, received roughly 40 percent of its 2011 revenue and $900 million of its $1.8 billion operating profit from China. Boeing, which cites China as its biggest customer outside the United States, has a 52 percent share of China’s commercial aircraft market; its business there is worth $4.8 billion, 7 percent of revenue. Nike, with revenues of over $2 billion in China and 16 percent market share in the country, reported in 2011 a Greater China operating margin (percentage profit before interest and taxes) of 38 percent, the envy of the corporate world.

But China is a much more difficult market than most company’s stock prices reflect. In a May study by the European Union Chamber of Commerce in China, a business advocacy group, half the 557 member companies surveyed said that market access and unspecified regulatory barriers limited business opportunities and hurt annual revenues by 10 to 50 percent. The American Chamber of Commerce in China found similar results in its 2012 survey.

Many firms in industries the Communist Party deems sensitive — such as oil, telecoms, and information technology — hit a ceiling once their company expands above a certain size. Because reaching economies of scale fuels long-term success, constricting market share damps U.S. company prospects in China. Although there are individual exceptions, U.S. companies’ share of the Chinese market has been shrinking. Industrial output by foreign-invested firms in China as a share of the national total peaked around 36 percent in 2003 and has declined ever since to about 27 percent in 2010, the most recent year for which data is available. The theft of sensitive technology, which leads to reduced market share, is also a concern. The technology firm American Superconductor claimed 70 percent of its business disappeared in 2011 after a Chinese partner convinced one of its employees to steal some of its technology. The November Economist Intelligence Unit report found that half the executives surveyed in big companies were concerned or very concerned they would be forced to give up their intellectual property in exchange for market access.

But the most unappreciated problem with investing in China is the unexpected risks that arise. "The government can close us down suddenly, or it can help native Chinese firms to steal our technology and gradually replace us in the market," says one U.S. CEO of his firm’s China operation who asked to remain anonymous. Foreign assets also face the threat of liquidation. Although they’re safe from Latin American-style government takeovers, China can de facto nationalize assets by exercising such strict control over taxes, regulations, and costs that it effectively controls and drains foreign firms’ profits. Nearly 40 foreign electricity producers rushed into China in the 1990s, lured by long-term contracts with guaranteed returns. Today, nearly all these firms have since exited, often selling their plants to the Chinese after being unable to make money as rising coal prices outstripped electricity-rate increases set by the state and as Chinese firms benefited from access to state credit and subsidized coal. And though unlikely, China could descend into political instability or an armed conflict with Japan, the Philippines, Taiwan, or Vietnam — a scenario in which foreign businesses would find it very difficult to operate. Such risks don’t receive enough attention from analysts and investment managers. In its biannual country risk survey, Euromoney magazine optimistically gives China a risk rating of 61.5 points (100 being least risky), compared to 75.7 for the United States and a 53.7 for India.

As with so many stock market fads, investors and analysts haven’t adequately incorporated the risks into stock prices. There’s a gap between the optimism presented on Wall Street and the difficulties of doing business in the Middle Kingdom, in part because CEOs are reluctant to speak publicly about these risks due to fear of Chinese retaliation against their businesses, which would make matters even worse. Think about the shock that greeted General Electric CEO Jeffrey Immelt in 2010 when he wondered aloud whether China wanted any foreign firm to "be successful." Two years later, Immelt said in a speech at Stanford University that "China is big, but it is hard," prompting a Wall Street Journal article explaining how Australia is set to generate more revenue for GE than China in 2012.

Indeed, China has been known to punish companies that publicly complain about doing business there. In Europe, EU Trade Commissioner Karel De Gucht even floated the idea of speaking out against abuses on companies’ behalf — and taking the heat — sparing companies from retaliation triggered by the filing of official complaints. "It is undeniable that many European companies are unwilling to come forward and make justified trade defense complaints due to fear of consequences for their business," he said in May. The result of all this silence is that information about the downsides of working in China doesn’t get priced into the market.

Hundreds of companies have been suckered into pursuing China strategies based on faulty expectations. Currently, the expectations of the market are high. When Caterpillar announced in April a slowdown in the growth of its China business — China makes up only 3 percent of its global sales — its stock fell 5 percent. That was in spite of the company earning a quarterly profit of $1.6 billion. When Apple reported in late July that sales in China had fallen 28 percent from the previous quarter (though they had risen 48 percent from the year before), Apple’s stock fell 5 percent.

The question isn’t whether companies can continue to operate in China, but whether they can earn margins on their investments that justify the risk. The American Chamber of Commerce survey found that 61 percent of companies surveyed report operating margins that are comparable to, or less than, their worldwide margins. From a shareholder’s point of view, that’s hardly a glittering statistic. Only one of three companies, in other words, is more profitable in China than elsewhere in the world — in spite of the added risks. If companies adequately factored risks into their investment decisions, few would find China investments passing their profitability thresholds for long-term investments. And many CFOs would disqualify investments that have only a 39 percent chance of exceeding average profits, in a country much riskier than their home market.

Analysts and executives, however, will no doubt continue to portray the growth potential of China as too big to miss, highlighting the potential profit and discounting the growing challenges and risks. But as analysts tally the current value of verifiable long-term cash flows, the stock prices of firms built on the China story will weaken. Investors, once they appreciate the meager potential, will drop the stocks. And prices will follow. CEOs, beware.