Beware Some Chinese Stocks

You’ve heard of bulls in a china shop? Well, I’ve been criticized for being a “perma-bull” on China stocks, and while it is absolutely true that I believe that China has several decades of great growth ahead of it … I have never suggested that all Chinese stocks are great investments.

In fact, I think many are mediocre, and some are downright dangerous. Here are two examples of Chinese companies that I wouldn’t touch with a 10-foot pole.

China Life Insurance (LFC), the largest insurance company in China, reported a 29 percent increase in its first-half profits to $2.7 billion. That sounds good on the surface, but there were several pieces of ugly facts hidden below the headline number.

 29 percent profit growth sounds nice but not when it was well below the $3.3 billion in profits that Wall Street was expecting.

China Life Insurance’s first-half sales fell by 54 percent.

 First-half premium income fell from $26.4 billion to $25.1 from a year earlier. The big problem was a 54 percent drop in group/corporate sales.

 LFC reported very strong quarterly profits not from strong sales of life insurance products but from strong results on its investment portfolio. Approximately two-thirds of its profits were from portfolio gains. If not for those portfolio gains, China Life would have fallen flat on its face.

 Not only did its stock portfolio do well, it made a good decision to reduce its fixed-income holdings and load up on equities. That’s a good piece of market timing, but it could just as easily work against profits in the future.

Do you remember the portfolio gains that companies such as Intel, Dell, and Cisco all included in their earnings during the dot-com boom?

Well, investors learned the hard way that stock market gains don’t last forever, and China Life is playing the same silly earnings manipulation game.

I’ve always been skeptical about financial companies — banks, brokers, insurance companies — because it is so easy to manipulate their earnings with accounting tricks like off-balance sheet financing, channel stuffing, special purpose entities, and pension plan pinching.

In fact, China Life looks like an accident waiting to happen to me on a fundamental basis, and even though the Chinese stock market is hot, China Life has rolled over from its 52-week high and looks like it’s headed lower.

In the interests of full disclosure, I need to tell you that my Asia Stock Options subscribers own put options (a bet on a lower stock price) on China Life, and we are so far doing fantastic.

Warning: Options aren’t for everybody because they involve a higher degree of risk and are not suitable for most investors. But options can be an extremely lucrative way to profit from short-term price swings.

China Life isn’t the only Asian company using some one-time gains to goose its quarterly profits.

Air China (OTC: AIRYY) is the largest airline in the world by market value, and it reported more than a 100 percent increase in its first-half profits. Profits jumped from $180 million last year to $422 million this year.

Sounds good, right? Hold on … there’s more.

 Revenues dropped by 9.6 percent as international passenger traffic decreased by 10 percent.

Air China is in for a bumpy ride as passenger traffic and cargo take a dive.

 Air China lowered its 2009 forecast for passenger traffic from 40.1 million to 39.7 million and lowered its cargo shipments from 1.01 million tons to 967,000 tons.

 The biggest warning sign is the big jump in profits was from fuel-hedging strategies. More than half of its profits were from gains on its futures contract holdings.

By the way, Air China recently announced that it was spending $812.8 million to increase its stake in Cathay Pacific Airline by 12.5 percent. In this slowing economy, that seems like a foolish strategy that will depress profits even more going forward.

Just like China Life, Air China is using portfolio gains to increase its short-term profit reports. Can either one of those companies continue to deliver those oversized portfolio gains next quarter? The quarter after that?

I don’t think so.

Furthermore, I have learned (the hard way) to stay away from capital-intensive businesses, like airlines and steel mills, because they periodically and regularly are forced to spend billions of dollars to upgrade their facilities and/or equipment.

Clearly, you just can’t buy China and expect to make money. You have to do your homework, dig for the devilish details in the fine print, and be very selective with your investment dollars.

That’s one of the reasons I’m not a big Exchange Traded Fund fan, either. You end up with a basket of stocks that often include crappy stocks.

For example, the iShares FTSE/Xinhua China 25 Index (FXI) is an extremely popular Chinese ETF with an average of 23 MILLION shares changing hands every day.

However, China Life is its fifth-biggest holding and represents 7.3 percent of the portfolio. Plus, the four other largest holdings are all banks, which are the financial companies I always fear to be guilty of financial hanky-panky.

That is especially true of Chinese banks that are owned and controlled by the Communist Party, such as the Bank of China, Bank of Communications, and China Construction Bank.

There isn’t a bigger opportunity anywhere in the world for investors than in China, but it is also the most dangerous place to invest because so many ‘bear’ stocks have been bid up like bulls simply because they do business in China’s investing shop. Be careful!

Regards,

Tony

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