Perhaps no investment opportunity has captured the minds of investors in recent years more than China has. That's partly because, according to the World Bank, China has been the largest single contributor to world growth since the 2008 financial crisis. And in 2018, the country represented nearly 19% of the world's population.
Inevitably, China will have hiccups as it proceeds to lead the global growth of the economy. The ongoing trade wars between the U.S. and China have caused some uncertainty for the future of both countries, and the World Bank notes that in order for China's growth to be sustainable in the long term, the country will have to make some big policy changes.
Before making investments related to China, investors should consider the pitfalls, understand the risks and rewards, focus on shareholder-friendly companies, and stick to investments they understand.
- China's urbanization, which is expected to continue past 2030, has led to its impressive economic growth.
- Some of the risks associated with investing in China include its communist structure, regulatory differences, and insider trading.
- Investment opportunities in China include U.S. corporations that have a presence in the country, mutual funds, and ETFs.
China and Urbanization
Urbanization has single-handedly led to China's impressive economic growth, and the country will continue to urbanize. It's taken three decades of economic reform for China's population to move from being highly rural to more urban, and it's expected that China has another 20 years or more of urbanization ahead of it.
As people shift from living an agrarian lifestyle to an urbanized one, a lot has to happen. Cities need to be developed and built, which requires growth in infrastructure, commerce, and other services. Economies shift as individuals stop working simply to sustain themselves and, instead, begin to specialize. That specialization requires more education, and an educated society is typically a wealthier society. As per capita wealth improves, the quality of life improves. During this process, businesses begin to sprout up, many of which create tremendous wealth for shareholders.
China's GDP in 2018 as per the International Monetary Fund.
The China of just a few years ago is often compared to America right before the industrial revolution. It's a fairly accurate comparison if you set aside some fundamental differences between the two. Growth in the 21st century will likely belong to China, just as growth in the 20th century belonged to the United States. That growth will likely create trillions of dollars in economic output in the near future, which is why many people continue to consider investment opportunities in China.
Understanding the Risk and Reward
To make the most of any investment and related reward in China, any intelligent investor should have a clear understanding of the risks involved. A detailed analysis of all the potential risks of investing in China is well beyond the scope of this article, but understanding the basic layout provides a solid foundation. It's important to understand risks should not deter investment, but as an investor, you should strive to understand them properly to account for them.
First and foremost, China is still a communist country. So despite the free-market principles, China has adopted, the rules that govern a public company in China are different than those in the U.S.
Chinese stocks trade on the Shanghai Stock Exchange and the Hong Kong Stock Exchange. Both exchanges have similar listing requirements to those of U.S. exchanges. Companies have to report financial statements regularly, have audits performed, and meet other requirements of size and capitalization. Beyond that, however, rules and norms differ, which is where things get murky.
Not only do Chinese accounting standards differ from the U.S. generally accepted accounting principles (GAAP), but regulatory differences abound. One common difference is the trading of company stock by insiders. In the U.S., insider trading is regulated intensively—the integrity of a market-based system rests on the premise that securities trading is not being manipulated by corporate insiders. In 2008, China banned trading by large shareholders in the month before companies release financial reports. However, academic studies suggest insider trading is still an issue in the country. A 2013 study in the International Journal of Accounting and Financial Reporting found China’s insider trading laws are still, “Catching up with the rest of the world.”
Chinese companies use Chinese Accounting Standards (CAS) also known as Chinese Generally Accepted Accounting Principles.
A Mosaic of Options
Investors interested in owning a piece of the China investment story have an abundance of investment products available. As expected, some options are much better than others, and some options should be avoided altogether or left to the most sophisticated investors.
Many investors may be interested in sticking with what they know—U.S. companies growing business in China. They can offer the best of both worlds: the advantage of U.S.-regulated, GAAP-adhering public companies along with the profit growth potential coming from China.
A great example is Yum! Brands (YUM), owner of Pizza Hut, KFC, and Taco Bell. These chains have seen a surge of growth in China and the country has increasingly been a source of profit for the company. Other large-cap companies that derive a significant portion of their profits from China include Nike (NKE), Starbucks (SBUX) and Apple (AAPL).
Investors interested in owning a share of companies that list on Chinese exchanges should look to professionally managed funds that focus on China. Many asset managers that offer China-focused funds have analysts in China who visit and vet companies before investing in them. Many of these funds also hedge their yuan (or renminbi) exposure back to the U.S. dollar, reducing another source of risk for a U.S. investor. Some of these funds come with higher expense ratios than domestic equity funds—another thing to consider before jumping in.
Another consideration is an exchange-traded fund (ETF). There are plenty of options available that focus on Chinese equities, giving you the chance to invest in China-based corporations. Keep in mind, though, that the growth of the majority of these ETFs has been hampered by trade tensions between Washington and Beijing.
There are more than 50 China ETFs that trade in the United States.
Anyone looking to invest directly in companies should consider focusing on blue-chip companies in China. These companies are readily established, have deep financial operations, and a bigger shareholder base, thus offering investors greater safety in a region still characterized by uncertainty.
Many Chinese companies are also listed directly on U.S. stock exchanges. Many years ago, these companies were market darlings. In recent years, however, virtually all of them have come under intense scrutiny due to the inability of investors to trust their financial statements. Unable to regain investor confidence, many U.S.-listed Chinese companies' share prices decreased significantly. Still, this category provides disciplined investors with an opportunity to find some attractive opportunities that are easier to research and trade.