By Tom Au

In 1982, a rookie analyst just out of school (Yale University) uncovered one of the biggest insurance scandals of his time. With the benefit of hindsight, the analysis was “simple.” A tour of state insurance agencies revealed that the company was losing money in its core insurance business. A check of non-financial operations disclosed that these weren’t making money either. So why then, was the company generating, or rather booking, huge profits? It was selling tax shelters, and booking hoped-for tax credits without the blessing of the Internal Revenue Service (IRS). Only a small fraction of these reported profits was represented by actual cash generation. So when these tax credits had to come off the books, the company, Baldwin United, was revealed for the empty shell that it was. The analyst was one James Chanos, who would make his career as a short-seller.

Fast-forward to 2000. Enron, a formerly “boring” utility, was considered a visionary, “new era,” quasi high-tech company. But its venture into broadband caught Chanos’ eye. This was a capital intensive, cash-eating business that would not pay off for years. Chanos didn’t initially consider Enron fraudulent (although he would soon change his mind after digging deeper). But what he saw at first glance troubled him: Even if Enron’s numbers were honestly reported, the company wasn’t earning its cost of capital, or at least it shouldn’t have been.

What was happening was that excitement about Enron’s “new era” prospects had caused investors to award an inordinately high P/E ratio for the company’s shares, thereby giving it an artificially low cost of equity capital that was less than its cost of debt. (Equity is supposed to be more expensive because of its greater risk.)  So Enron was economically profitable only because Peter-Pan like investors saying “I believe” were providing capital at artificially low rates.

But Enron, like most high-tech companies, had to continually raise new capital in order to expand. Someday, an “accident” could puncture the myth of Enron’s economic profitability. When this happened, a capital raise might fail, thereby sending the company into reverse. And revelations of corporate malfeasance provided such an “accident” late in 2001.

China may be another such accident waiting to happen. Like those of the two above-mentioned companies, Chinese growth has always been about volume, rather than value. Hence, there are physical limits to such growth that the country may be bumping up against. (For instance, a human body cannot consume twice the volume of food from year to year, only twice as much value, in terms of more expensive food.) And (all other things being equal), increased volume often decreases value.

One example was the reported steel production during (1950s) Great Leap Forward. The “program” seemed simple. Tear down the existing infrastructure. Run the proceeds through “socialist” blast furnaces built “overnight” in peoples’ backyards. Double the annual output of “steel.” But reduce its quality to a fraction of what it was earlier, thereby destroying “value.”

China has since shed its formerly shoddy image, and in fact, has gained a nearly “bullet-proof” reputation. In Greek mythology, Achilles was the greatest warrior of his time because he was all but invulnerable to wounds. This came about, because his mother, a goddess, had immunized him by dipping him into the River Styx, holding him by the heel. Only the heel had not been dipped into the river, and was vulnerable. But Achilles was brought down by a poisoned arrow shot into that heel.

Baldwin United’s Achilles heel was the lack of legitimacy of its tax credits, coupled with its lack of profitability. Enron’s was its cost of capital (relative to the low profitability of its ventures). China is clearly profitable, but its Achilles heel is that it has poorly developed endmarkets. That, as much as anything else, is why the country needs to export. The country is great at production, but not nearly as good distribution and consumption. So it largely depends on foreign economic agents (waibangren in Chinese) to carry out these functions. Left to its own devices, China will likely overproduce, and it may experience steroidal “immiserizing” growth (flooding the market with commodities, thereby lowering prices to the point where “value,” the product of price times quantity, actually declines).

The reason is that Chinese economic (and other) reporting is problematic. We don’t think that they are lying, outright. A better characterization of Chinese statistics might be “legally accurate but not volunteering information.” That is, China may be saying things that are literally true, but not “accurate” as a Westerner would understand it. That is, the economy may be growing in the literal sense, while destroying economic value just as Baldwin United and Enron did. If so, a lot of what now passes for investment will turn out to have been misdirected, and therefore wasteful. And such wastefulness is what typically brings about a crash.

A large part of Chinese economic development is “frozen,” into single-use assets that cannot be profitably redeployed if the original use goes out of fashion. That’s because, by the admission of apologists like Shaun Rein, China is much like a teenager at this point, growing much faster in some areas than others. An example is the explosion of Chinese urban real estate. Early in the economic cycle, it is a sign of progress. But late in the cycle, it is not only an albatross, but a symbol of excess, just like the construction of America’s Empire State Building in 1930 became an unfortunate symbol of the Great Depression. Likewise, the recent Chinese stockpiling of minerals and capital goods might not soon find suitable outlets if export markets dry up, as they have been doing. China reportedly produces 50% of the world’s steel. But without the benefit of export markets, could China use that much steel on its own? Not unless its internal market suddenly becomes far more efficient than it has been up to now?

Chinese growth might be less problematic if it had a stronger private sector. But China is, and remains, a socialist country, which means that state “needs” receive priority, whether or not they make economic sense. One example is the continuation of State Owned Enterprises (SOEs) to maintain employment, and hence social harmony. To be sure, America has its own versions of “brain-dead” government sponsored entities such as Fannie Mae and Freddie Mac, but fortunately, they are not (yet) engraved into the culture. China’s problem with comparable enterprises is at least ten times, and more likely a factor thereof, as large. Meanwhile, consumer demands count for less than they would in a free-market economy; consider the recent brouhaha about censorship of Google, a “foreign” company. All in all, we believe that China is an economic Paper Tiger, much like the former Soviet Union. 

Tom Au has over twenty years of experience in securities analysis and portfolio management for both equity and fixed income securities. He has worked for Value Line, Cigna Investment Management, and other organizations. Prior to joining R.W. Wentworth, he was an analyst of the "monoline" municipal bond insurance companies. He is the author of A Modern Approach to Graham and Dodd Investing (Wiley, 2004).