Straight Talk On Chinese Stocks John Dobosz, 07.21.06, 11:00 AM ET

NEW YORK - Tim Heidorn is a 46 year-old investor living in Taipei, Taiwan, with his wife. He manages a small, family owned and operated export trading company dealing in hand tools and automotive accessories, exporting from factories located in Taiwan and continental China. The native "Cornhusker" grew up in Nebraska, the son of the principal of the Lutheran grade school. He received a Bachelor's degree in biology from the University of Nebraska, and later a Master's degree in ecology and evolutionary biology.

After college, he worked in consumer marketing research at Hallmark Greeting Cards and then at the Kwikset door hardware division of Black & Decker (nyse: BDK) that was located in Anaheim, Calif., at that time. He moved to Taiwan in 1993 with his Taiwanese wife-to-be and worked in Taiwan as a consumer research consultant. He joined his wife's family business when their daughter was born nine years ago.

Heidorn is a popular discussion participant on, where he is known as "Taiwan Tim." He is known as something of a sage for his timely picks of China Yuchai International (nyse: CYD) in 2003 and China Life Insurance (nyse: LFC) earlier this year -- along with his short of UTStarcom (nasdaq: UTSI) in 2005. We decided to ask him a few questions by e-mail about the promise and the pitfalls of investing in China. What are some key lessons you've learned from living in Taiwan and investing in China?

Heidorn: The most important thing I can stress to your readers is that investments in China are typically not publicly traded stocks; investments take the form of private loans and private equity and you need to be there, in China, Hong Kong, Macao or Taiwan, to truly invest in the way most people define the word "investment."

Individual, publicly traded China stocks should not be considered buy and hold investments. They are trading stocks. If you don't take that attitude, you may be in for some frustration.

The second most important thing I can stress is that the infrastructure of stock fraud is highly developed in the "Greater China" region. Stocks that trade on European and American exchanges are manipulated through criminal activity that takes place among foreign nationals living outside the jurisdictions of the markets where the exchanges reside. Although a supervisory agency like the SEC could prosecute and try to extradite the fraudsters, I've never seen it happen. High insider ownership is sometimes an invitation for fraud with small cap Chinese stocks. A U.S. listing and analyst coverage are no protection.

Big Chinese state-owned firms have done rather well. What are your views on investing in these types of companies and what are some of the pros and cons, e.g. they're owned by communist dictators, they are not totally transparent?

My opinion on this issue might be controversial. In my opinion, the big China state owned enterprises (SOE) are the best ways to own a direct piece of Chinese growth. If I had to name one vehicle to own, it would be the iShares FTSE/Xinhua China 25 Index. It is not that I have a great appreciation for state ownership or the lack of transparency which are both evidenced in these stocks.

The thing I like about the SOEs is that they will not be allowed to fail as a matter of national pride if nothing else (the Chinese Communist Party will come up with cash to keep them going or structure the competitive environment in a way that benefits their own companies). The other thing I like about the SOEs is that starting in late 2005, they have been the prime beneficiaries of the liberalization of China's capital markets. These are the stocks that are attracting large foreign portfolio flows.

"Investing in China" doesn't always mean literally investing in companies based in Mainland China. Talk a bit about playing China from different angles, e.g. via companies or countries that benefit directly or indirectly from Chinese growth.

The best examples of this are the global energy and metals companies that are benefiting from China's demand growth. Korea's POSCO is a prime example. However, that indirect method of investing in China growth is so well known already that it may have gotten overdone and it has certainly been over-repeated in the press. One thing that many people tend to overlook is that the continental Chinese economy is only part of the greater Chinese economy, which includes Taiwan, Hong Kong and the ethnic Chinese of Singapore, Malaysia, Indonesia, Philippines, Canada and the U.S. The Chinese economy has developed the way it has because of the private investments of ethnic Chinese who are not actually PRC citizens. When you own Hong Kong or Taiwan stocks, you generally own a piece of the continent. Many Silicon Valley stocks (OPLK for example) are also really China growth stocks.

Taiwan is perhaps the world's capital of electronic contract manufacturing, especially for laptop computers and semiconductors. What are some good plays there right now…and should investors be concerned about Chinese missiles and troops wiping out their investments?

Ha ha! Funny you should put it that way! Taiwanese corporations are often world leaders in contract manufacturing, but most of the physical work takes place in continental China (here in Taiwan, China is often referred to simply as "The Continent"). That's where the physical products are most often shipped from. There is still plenty of manufacturing takes place here on Taiwan to, but Taiwan's role is increasingly design, management and finance. The only way you can conveniently own a diversified basket of Taiwan stocks is to own the ETF iShares Taiwan Index or the Taiwan closed end fund. Mutual funds might be fine too, but I don't keep track on any specifically. I often hold and trade three Taiwanese "tech" companies Taiwan Semiconductor, ASE Test and AU Optronics. These necessarily ride the tech and semiconductor cycles, and I don't own any of them right now.

The problem with Taiwan is, as you mentioned, politics. Rarely will you see two economies so thoroughly integrated as Taiwan and China are, with politicians who do not communicate officially (rest assured there is plenty of unofficial communication, approximately one million Taiwanese citizens work and live on the mainland--that's about 4% of Taiwan's population and a friend in Shanghai recently told me 80% of the restaurants in Shanghai are Taiwanese owned according to a current survey).

However, you should be aware that I don't know of a single Taiwanese personally who is the least bit concerned about mainland Chinese taking military action against Taiwan. They all figure that the Chinese Communist Party is just blowing smoke and trying to pump up their domestic support with their tough line. Everybody knows that military action against Taiwan would be an act of economic suicide for Beijing. Unfortunately, Beijing says they are serious and there is a hard core 30%--40% of Taiwan public opinion that wants Taiwan to be as independent from China as Austria is from Germany. Both sides employ brinkmanship. The only thing I can say is that a full scale invasion or blockade of Taiwan by Beijing will trigger a global recession and render most Chinese, Hong Kong and Taiwanese stocks worthless, but that would be the least of your worries.

What role can exchange traded funds and mutual funds play in profiting from China? Which ones do you recommend?

I have not owned a mutual fund since 2003, so my opinion is mute on that subject, but if your plan is to be a relatively passive investor in China, diversification is of the essence. You are not investing in Chinese growth so much as joining the global capital flows into the country. These capital flows (be they foreign direct investment or your next door neighbor buying an ADR like LFC) make up a significant portion of the GDP growth statistics for any given quarter or year. This sea of capital floats all boats. It is best to own many boats, because, even on the great capital sea, some individual boats sink. That's why I am steering your average investor toward the iShares FTSE/Xinhua China 25 Index. First, these are the only companies big enough to really absorb all of the potential portfolio inflows without spiking to crazy prices, second, these state-owned enterprises benefit from the "Beijing Put" they simply will not be allowed to fail, although it is important to remember they can trade down for months and years on end (see 2004 - 2005).

On the other hand, if you're looking for a diversified investment that has some state owned enterprise (SOE) and private company exposure, I recommend looking at the Greater China Closed End Fund. As with any CEF, it is best to buy at a discount. This fund not only holds a variety of important SOEs, it also has property and contract manufacturers that can not be purchased as individual ADRs on foreign exchanges. Last time I looked, GCH is trading at a small discount and yielding 6%. Individuals should always do their own investigation of CEFs because the discounts change daily and the yield is not guaranteed.

What are the dominant themes on the growth of Chinese consumers and businesses that shape your investment strategies?

My dominant themes on Chinese consumer growth are:

1. Competition is fierce and entrepreneurial.

2. Chinese consumer's habits change fast.

3. The supply of stocks listed internationally is very limited, and investor interest in them is very high.

When we combine these three themes you can see why the only real investments in Chinese growth must be found by going to China yourself and lending money directly or starting your own business. Whenever I encounter a really good idea in a Chinese stock--I'll use International and 51job Inc. as examples--the assumptions for future growth are usually over extrapolated and they sport P/E multiples of 50 or more. If these companies had barriers to competitive entry that we could count on, you could justify P/E multiples like that, but, as it is, the real investment opportunity is to go to China, poach some skilled employees who work for CTRP and JOBS, start up a new company that competes directly with them and take market share. The market for these services is growing so fast that there's plenty of room for competitors. Unfortunately, it will slow the growth of companies with stock listed in the U.S., and those price earnings multiples will look crazy when earnings growth disappoints. I wish the owners of those stocks the best fortune and I hope they make good profits. Just remember, those are trading stocks, not investments.

Tell me about a few of the investments that you think are priced attractively for buying right now?

I still like China Life Insurance. For the most part, the market is rigged in their favor. They have competition, but the next biggest company is another SOE, Ping An. That's like, "our politicians vs. your politicians"--not a real competitor that will be allowed to really hurt LFC. The rules that govern what LFC can do with the huge quantity of savings of Chinese citizens have been recently liberalized. Part of what LFC can now do is to invest Chinese cash abroad. The government needs to develop outlets to get some of the foreign money back out of China to relieve the investment bubble and allow for a real free flow of capital and a floating currency. You really can't evaluate LFC by looking at their past business because the rules have changed so much. It probably still has some upside left.

What could derail the Chinese growth story and badly burn investors…and are there places to invest where you would not be as directly exposed to such calamities?

The most serious calamity is one you really can't avoid if it happens. It would be something that disrupts of reduces the flow of foreign money coming into the country. In fact we might be getting ready to see some of that now, if the Bank Of Japan is really serious about raising their interest rates and reducing growth in money supply, less of that free money will flow to China. But the real doozy would be a significant political disruption like the late 1980s Tiananmen Square protests or military action with Taiwan. China would survive such calamities, but foreign investments would not.

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