Going Global

China's Stock Markets -- Irrational Exuberance or Just Lot's More Money?

Just as with its economy, China's stock markets have been among the hottest in the world.  As the indexes have continued to rocket toward new record highs, the financial press has warned of the inevitable bursting bubble that follows such speculative investing -- or what Alan Greenspan once famously called "irrational exuberance".

After many years of investing, I've developed a certain sense of humor about the varied explanations for the daily fluctuations in various stock market indexes here in the U.S.   Of course with streaming internet news, those explanations are now minute by minute.  "Drop in Oil Prices Fuels Market Rally".  "Shaky Consumer Confidence Leads to Sell-Off".  I don't see big money suddenly moving in or out of the market based on big trends that are continuous and progressive for extended periods of time.

It seems to me there are two big engines driving money in, out and around the stock market -- (1) investors (whether individuals, firms or funds) looking to buy into good companies and (2) investors looking to mirror certain asset allocation criteria, whether a particular index of companies or a given mix between asset classes, industries and companies.  Decisions will be impacted by news that changes the assumptions about a particular company, price changes that alter the dollar mix of the portfolio, and, of course, the risk adjusted return available on alternative investment vehicles.  I don't see them being much affected by hour to hour changes in the price of oil futures. 

At the end of the day, the thing that makes indexes made up of multiple companies move over sustained periods of time in one direction or the other is the same thing that moves most other markets -- supply and demand.  Certainly one of the biggest drivers of the sustained stock market rally in the US in the '90s was changes in the tax laws, regarding 401K's for example, which produced bundles of cash in search of an investment.   The demand for investable assets drove the price of stocks as a whole upward.

The hockey stick curve that represents the trend in China's stock markets could be the result of crazy people throwing their money away.  But I think more likely, its caused by the rapidly increased demand for investable assets, resulting from so many people moving up the economic ladder, chasing a limited number of alternatives with competitive risk adjusted yields.   Which is not to say that its not risky, but it is to say that the exuberance might be rational.

So what does this indicate for the company trying to assess the prospects of business in China?  Don't be swayed by the headlines about the crazy hyper-speculative stock market, (unless your business is to invest money in those markets).   Instead you can view the activity as another symptom of a fast growing economy made up of lots of new middle class consumers with money to spend on your product (at least if the value of your product is more than the potential return in the stock market).

[Note of attribution: Pogo stick riding investor photo from an article appearing at Today's Seniors Network.com].

Morningstar in China -- An Individual Investor's View

China is such a hot market that any business thinking about going global is considering whether there is a China strategy that makes sense for their business.  And for individuals who don't have a business to take to China, there seems to be an insatiable interest in finding Chinese stocks to ignite their portfolio.  With that in mind, I thought I would share some of the insights contained in the current issue of Morningstar's StockInvestor newsletter.

Paul Larsen, the newsletter's equities strategist and editor, just returned from a month in China, training stock analysts for the company's new office in Shenzhen as well as getting his own arms around what's happening in the mainland's market.  He devotes much of the April issue to his observations.

He sees a number of competitive advantages enjoyed by Chinese companies, including:

• lax environmental restrictions ("[y]ou can forget the stories about an emerging environmental disaster happening here.  It has already happened". For more on pollution in China, see one of the many detailed posts relating to this subject on the China Law Blog)
• lax safety standards (the subject of a recent post on this blog as it relates to the lower cost of Chinese exports)
• a political structure which allows macro economic decisions to be made quickly without debate (depending on how those decisions turn out, this of course could be a disadvantage as well -- so far so good for the most part).

He also cites a number of competitive disadvantages:

• imperfect capital allocation (the invisible hand "is only operating with three fingers in China").
• corruption, nepotism and other systemic inefficiencies.

The principle issues that he sees facing investors in China are:

• the government's role as both major shareholder and regulator creates conflicts of interest which pose an uneven playing field for the individual investor;
• the markets do not have a mechanism such as short selling to allow market efficiencies to operate in both up and down market cycles;
• because Chinese investors are not permitted to invest outside of China and the only competing publicly available investment vehicles are low yielding bank deposit accounts, the country is flooded with capital, causing Chinese stock prices to be inflated in excess of their intrinsic value.

As a result of these issues, Larsen is left exactly where it seems so many stock advisory services come out when looking at China -- noting that it is an undeniably hot economy as a whole but facing great difficulty in specifying individual companies that trade at an attractive current price relative to their valuation adjusted by a reasonable margin of safety.  While he does delve deeper into a few specific companies that he thinks have potential, his bottom line conclusion is "unfortunately everything I found was either too scary (far outside my circle of competence or risk tolerance zone), too expensive (I'm here late in the boom), or cannot easily be purchased by foreigners". 

My own experience is that Morningstar is among the most rational (straight-talk, not hype) analytical services for individual investors, so I put some stock in what Larsen has to say about the Chinese market.  All things considered, building a business in China may well be the most sensible way to profit from its booming economy.  At least you have some control over the value that is created.

How Big Is the "Real" Market in China - Redux

In a post some time ago I raised the question as to the size of the real consumer market in China.  I think this is relevant to companies looking to China as a potential market because I see many companies heading off to China with stars in their eyes -- or more accurately, the idea of 1.3 billion people in their business plan.  The reality, of course, is that while China is unquestionably a very large market and growing at a rapid pace, the majority of China's citizens live at a level where they are not participants in the consumer market for foreign goods and services.  Whether it's because the government launders most official statistics or because China is such a moving target (mostly moving forward), it seems difficult to get a handle on data that could better calibrate the real size of the consumer market.

I was prompted to raise this question again after reading an article in today's New York Times entitled "Internet Boom in China Is Built on Virtual Fun" (subscription may be required for the on-line version; the article appeared on p. 1, col. 5 in the February 5, 2007 print edition).  The article profiles Pony Ma, who is described as "China's closest approximation to Sergey Brin and Larry Paige" of Google, and his booming internet company Tencent.  Positing that Tencent dominates its market like "no other internet company in the world -- not even Google", the article states that since its IPO in Hong Kong, Tencent "has grown into a powerhouse that has crushed everyone else in the field."  To emphasize the point, Deutsche Bank internet analyst William Bo Bean is quoted as saying "everyone talks about eyeballs.  Well, they've got all the eyeballs in China."

With that effusive background, here is the data point I'm trying to get my arms around -- the article states that Tencent "has reached more than 100 million [internet] users, or nearly 80 percent of the market."  If "more than 100 million" means, say 120 million or so, then the 80 percent figure would imply a market size of about 150 million internet users.   That number is much much lower than what I think most people would use for the consumer market in China, and certainly pales in comparison to other proxy numbers such as the more than 400 million cell phone users.

In general given that fact that the internet is becoming more and more part of the essential fabric of consumerism in an information driven economy and also given the relatively modest cost of gaining access to the internet, I would have expected the number of users in China to be much higher.  As noted in my recent post on NationMaster.com, it seems that good data on internet users is hard to come by -- and maybe its more so in China.  I am also wondering whether the government's concern with the connection between the free flow of information across the internet and political freedom might in fact have dampened the number of internet users in China relative to the number of consumers there.

Maybe I should just give up this quest and go with the fact that China is really really big and growing bigger all the time -- but that seems like a bit of a loosey-goosey data point on which to base the analysis of a potential foreign market.

Don't Get Scammed by a Would-Be Partner

We've all received the spam e-mail from some Nigerian barrister letting us know that we could earn a sizable commission just by allowing them to move some recently discovered funds through our bank account.   All the better of course if the funds were left by a wealthy official who was allegedly a distant but heir-less relative of ours -- we might even be in for a piece of the inheritance.  As savvy business people we see right through these laughable scams wondering who could be so naive.

Targets for the "I just need an advance up front to make the deal go" scheme are not limited to the individual e-mail account, however.  These scams can be and are aimed at businesses seeking to gain an edge in dealing in foreign countries where our unfamiliarity with customs and the challenges of getting straight answers in due diligence create enough disorientation to make these cons effective even when played on otherwise sophisticated business people.

In an excellent post entitled "Avoiding the China Buyer Scam" from a couple of weeks ago, the China Law Blog provided an excellent recap of just such a business scam with currency in China.   More importantly, the post, which expands on an earlier article on these scams from the China Business Services Blog, contains some sage advice on how to spot and avoid these black holes for the unsuspecting business.

Don't shrug this off as something that could never happen to you.   As the China Law Blog notes from direct experience with clients who have been had or nearly had, it's surprising how many businesses get sucked in.  To reiterate a constant theme here, have the patience and take the time to develop relationships and understand the business environment in a new foreign market -- or hire the expertise from a trusted source.  As with any business deal, the aim is to maximize the probability of a positive return on your investment.  To do that, you should do what is necessary to mitigate the risks imposed by unfamiliarity.      

[Note:  The facsimile of the fake Nigerian certificate of deposit is found on the jw Spam Spy site in an article on what's known as the "419 scam" or "the dead foreigner scam"].

China is to the U.S. as the U.S. was to Europe

In an intriguing new book out last month entitled "In China's Shadow: The Crisis of American Entrepreneurship", Reed Hundt, former FCC chairman and current senior adviser on the information industry with McKinsey & Company, undertakes a policy analysis of the challenges that China's rise as an economic power poses to the position of the United States in the world.  His take is refreshing in that it is neither a doom and gloom "fall of the modern Roman empire" tome nor a pollyanna look at the U.S.'s "rightful" place atop global commerce.  The book takes a hard and realistic view of the dynamics of China's current engine for economic growth and makes some very specific policy suggestions that Hundt believes would allow the U.S. to successfully meet the inevitable challenges.

The theme of the book is echoed in an op-ed piece that Hundt published in the Denver Post this past weekend.  One of the points that I found both novel and insightful is his comparison of the United States's position vis a vis China today to the relationship between Europe and the U.S. in the 19th century.  He presents Europe's policy responses to the rise of U.S. economic power as a model that we can learn from, mainly by not repeating the same mistakes, in responding to China's similar dramatic rise.  Instead of proactively positioning itself to move to the forefront of the sort of innovative entrepreneurship driving the American experiment forward, Europe tried to protect its historical supremacy by clinging to what it saw as the roots of its rightful position in the global hierarchy while trying to marginalize the extent of changes wrought by the emerging American business model.   The result of course was that the U.S. blew past Europe as the preeminent economy in the world, leaving Europe to struggle with chronic issues of stagnant growth and high structural unemployment which continue to challenge many EU countries today.

So what must the U.S. do to fashion a different fate in the face of the emerging boom in China?  Since I can't improve upon Hundt's own formulation, I'll quote from his op-ed piece:

To be more competitive, American firms have to be more entrepreneurial.  Creating trade barriers would only cut the impetus for American firms to remain at the top in terms of productivity and efficiency.  American firms need open markets in other countries but also in the United States so that competitive zeal can be encouraged and rewarded at home. . . .

The rise of China is a summons to tremendous economic competition.   Both countries will benefit if the fight is benign, fair, vigorous and wealth-creating for the whole world.

Change happens with or without us.  The way to win in the face of change is to embrace its reality and figure out how to win with the new rules of the game rather than to prefer that it not happen and cling desperately to an unsustainable past.

As Chinese Companies Gain Their Own Stake in IP Protection, Enforcement Begins to Improve

A number of years ago, I was in Poland looking at a potential acquisition.  One of the things that had attracted us to the company was the great success it was having in building a strong market position in the Ukraine.  On our visit to their operations, they explained that the success was the result of a carefully branded product that had strong appeal to the Ukrainian market.  We were excited to see the product in their shipping warehouse, but unable to make much of it since the product brand name was in Cyrillic and none of us could read Cyrillic.   When we asked what the name was that had such appeal, they told us proudly the name of the product -- you wouldn't recognize it unless you were in this particular industry, but within this market space, it was the equivalent of a chain of coffee shops telling you that their secret to success was to call their shops "Starbucks" -- so I'll use that to make the point of the story   We looked at them a little surprised and said "we didn't realize that you had a license agreement with Starbucks."  Without much chagrin they shrugged, smiled and said "We don't, but as far as we can tell, no one at Starbucks reads Cyrillic either." 

We didn't make the acquisition, and not just because of the risk of a lawsuit waiting to happen.   But the point is, protecting IP as it spreads out into distant foreign markets takes prudence, vigilance, and adequate legal protection and enforcement.  And the more foreign (among the attributes of which I would include (1) a different cultural orientation toward property rights and legal enforcement and (2) a place where one is not fluent in speaking or reading the language), the bigger challenge you face.   And certainly "challenge" is among the milder adjectives that many companies might use to describe their experience to date with protecting their IP in China.

But better days may lie ahead it seems.  In a post earlier this week entitled "Chinese Pirates Like Chinese Brands and That's a Good Thing", the China Law blog discusses improving trends in IP enforcement in China as reported in a post on the China Business Services blog, in turn based on an article in McClatchy Newspapers' on-line edition, written by the author of a blog on China -- China Rises: Notes from the Middle Kingdom.

The article reports that patent applications by Chinese companies rose 44% in 2005 and that IP lawsuits in China are up 50% year over year, with suits by foreign companies accounting for only 5% of that increase.  So it seems that indigenous Chinese companies are beginning to develop a sufficient stake in their own IP that protecting IP is beginning to be more of a real priority for the Chinese themselves.   Dan Harris expresses his opinion that the point has been reached with trademarks where "enough powerful Chinese companies are demanding real enforcement" that a "marked improvement" can be seen.  He cautions, however, that that point has not yet been reached with respect to patents or copyrights, "and certainly not with respect to movies or software."   

The China Law Blog and the China Business Services Blog both stress that "intellectual property rights (IPR) abuses remain a real risk when doing business in China", but it does appear that things are moving in the right direction and that Chinese courts are playing a more forceful role in the process.  It's amazing what a little skin in the game can do.   

Business Processes and Investment in China's SOE's -- The American Export that Won't Show Up in the Balance of Trade

There is an interesting article in the current issue of Strategy + Business entitled "China: Reform from the Outside In" which discusses the reasons behind and the impact of the change in policy initiated last year allowing direct foreign investment in China's state-owned enterprises ("SOE's").  The authors argue that the change was initiated not as a means of attracting more investment capital to China's state run operations, but rather to accelerate the adoption of western business management practices and more transparent financial controls in order to make them more competitive in China's increasingly open markets -- as well as putting them on firmer footing for competing in markets outside of China.

I am not quite ready to assume that there is no need to attract foreign investment capital as argued in the article.  While China certainly has impressive reported foreign reserves, with many remaining vestiges of state socialism still in place and given China's massive investments in infrastructure and urban development against a still small relative tax base, I think its difficult to assess the size of China's budget deficits and whether its foreign trade surpluses are sufficient to create a large enough total surplus that its state run business operations in fact do not need equity infusions.

Nonetheless, I think the transition to allowing direct foreign ownership can only be positive.  Certainly modernized management structures, business processes and financial controls will make the SOE's easier to do business with, whether as a customer, a supplier or an investor. 

Also, assuming the foreign investors do not grossly overpay for their ownership interests, these investments should provide a return of capital plus an attractive investment premium through the investors share of the SOE's profits.  The premium represents in some sense the payment by the Chinese for importing the business expertise that they are trying to instill in the SOE's.  It seems to me that this kind of transaction represents a very real export of intangible goods to China (largely from the U.S.) that will never be accounted for in the balance of trade statistics.

Walking the Tightrope to Profitability in China -- Must We Work Without a Net?

China is well known for its acrobats performing stunning feats high above the circus floor without a net.   I imagine its the same feeling that many foreign business people in China have.   I am struck over and over again about conversations with business people who are pumped about the opportunities in China but who have lost money pursuing them.   With so much growth and abounding economic opportunity, how can so many companies be losing money?   I think the answer lies in part in the greatly increased importance of contingency planning when putting together strategies to enter a quickly developing market such as China.

There is an interesting article in today's Wall Street Journal about the impact of the fast growing auto industry in China ("As China's Auto Market Booms, Leaders Clash Over Heavy Toll") which illustrates the kind of tension that can whipsaw market opportunities for the unwary.  Car sales are up over 50% in the first three months of 2006 alone.   Exacerbated by the low quality / high sulfur gasoline that all those new cars are forced to burn, however, China's cities face air pollution problems that have governments such as Beijing's considering such draconian (though perhaps ultimately necessary) measures as prohibiting all private cars within the city.   One of the greatest miracles of China's growth story has been the government's ability thus far to maintain the delicate balance between rapid growth and its negative impacts.  But it is a delicate balancing act indeed and looking at issues such as the one currently being debated between the economic boon of the booming auto industry and the looming environmental disaster can give one pause in deciding where on the growth curve to dive into the market.

Another interesting factoid in today's Journal was a table of countries with the worst and best records on software piracy.   China, to no one's surprise I suspect, was near the top of the worst.  I think the real message to business people outside the software industry is that China is a country of fast adapters eager and willing to bring promising new technologies "in-house".   Any market position that you develop will be under far more serious competitive assault here than in a more fully developed market.

The moral: unless you're comfortable making like a Chinese acrobat, create a net for your business plan -- increase the time and focus on the contingency portion of your plan for China.

India or China -- Round 2

India and China are obviously hot markets -- and handicapping the horse race between the two (although I think this is a race without any loser) is apparently a hot topic in itself.   For those of you interested in the earlier post on the comparative pros and cons of doing business in India vs. China, I commend to you the post by Dan Harris at his law firm's China Law Blog entitled  "The Better Investment?  China or India" which picks up this same theme.   

Dan's firm, Harris and Moure pllc located in Seattle, specializes in international law with a particular focus on China.  The firm is small, but seems to have some pretty impressive international talent.

How Big is the "Real" Market in China? -- Weigh in with Your Estimate

A good business plan requires reasonably reliable data.   When it comes to China, it seems as if many businesses start salivating at the notion that China has 1.3 billion people.   The problem is, of course, that the real consumer market in China, although growing rapidly, is much smaller than that.   But how large is it?   This is a particularly elusive question in a country where a great deal of available economic information is controlled by a government that doesn't yet trust the free flow of information.

Given the important but elusive nature of this key piece of information, I thought it might be useful to solicit input from as many business people as possible who may have a reasoned perspective -- sort of like a contest, but unfortunately with no prize -- except that we may all benefit from our collective insights.

Just to give some common starting point, here's a few pieces of data that may be relevant to the issue:

1. On an exchange rate basis, China had a GDP in 2005 of approximately $1.79 trillion, or less than half of the total economic productivity turned out by Japan's 125 million people.  On a purchasing power parity basis (as estimated by U.S. intelligence sources), China's 2005 GDP was closer to $8.18 trillion, or roughly twice that of Japan. (See CIA World Factbook for China / for Japan).
2. According to the China Daily News, there are approximately 240 million cell phone users in China.   This is over 2.5 times Japan's 90 million, but given the relatively undeveloped land-line communications infrastructure in much of China, as in many other developing economies,  this may be less an indicator of a middle class demand for discretionary consumer goods as much as a still under-utilized necessity -- you make the call.
3. As a measure of more expensive durable goods, the People's Daily reports that there are approximately 1 million cars sold in China per year as of 2005.  Compare that to the 16.9 million bought in the U.S. last year.

In addition to your comment on the size of the market, it would be great if you would share any other key data points which you see as benchmarks for this kind of analysis.   Post your comments below -- and please share a link to your website as well.  It should be interesting to see if there is a consensus around this issue or if there is a significant margin of error that needs to be accounted for in a China business strategy.