(07/12/11) China’s Sweet and Sour Markets

While there is always an undercurrent of excitement about investing opportunities in China, it’s a game even the pros can’t play successfully yet, observes Tom Taulli of InvestorPlace.com.

John Paulson has become the world’s greatest hedge-fund manager. He made billions when he shorted exotic mortgage investments in 2006 and 2007. Then, in 2009, he made billions when he went long on gold and financials like Bank of America (BAC) and Citigroup (C).

But lately, Paulson has hit a wall—perhaps, the “Great Wall.” You see, he lost a bundle on Sino-Forest (SNOFF; Toronto: TRE), a Chinese forestry company.

The catalyst was a report from short-seller Carson Block, who operates Muddy Waters, an online research service. Block alleged that Sino-Forest’s accounting was, well, dubious. The charge had some credibility given the fact that, over the past year, five short picks of Block’s have lost a stunning $5 billion in market cap.

It’s far from clear if China’s corporate system is riddled with bad apples. But it looks like Paulson wasn’t willing to test the hypothesis. He dumped his whole stake in Sino-Forest.

Keep in mind that Paulson was not the only one who got stung. Other investors—like Christopher Davis of Davis Selected Advisors—lost money on the company as well.

So if top-notch operators are having problems, how can the typical investor do any better?

If anything, it’s a good bet that US hedge-fund managers are going to avoid Chinese investments. After all, Paulson relied on Sino-Forest’s financial statements when making his investment. Now he says there is “uncertainty” with them.

Thus, if there is a lack of transparency, is it possible to really make effective investment decisions in the Red Dragon?

But this is just one of the issues regarding investing in Chinese companies. There are also some real concerns that its economy may be a house of cards as well.

For example, Gary Shilling recently published an excellent five-part article forecasting that the country is headed for a hard landing.

Shilling points out that China’s domestic spending is based on a weak foundation. As the population ages, there will be a growing need to save more money, putting further pressure on consumer demand.

Next, the Chinese government has plowed huge sums into capital investments, such as infrastructure. The result has been a surge in real estate and stock prices. Consider that apartments in Beijing are selling at roughly 22 times the average income, and it appears that about half of China’s GDP is related to real estate.

To put things into perspective, Shilling points to Japan during the 1980s. That country also was an export-driven economy, with a high savings rate and an aging population. And government actions similarly helped propel speculative bubbles in real estate and stock prices. When these popped, the economy experienced a two-decade period of stagnation.

Now this doesn’t imply that China’s economy will implode soon. Any bubble can certainly last for many years.

Yet in light of the recent accounting scandals and the flimsy legal rights afforded to foreigners, it is probably a good idea to cautious when it comes to investing in Chinese stocks.

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