At the height of the dot-com bubble in 1999, the magic word for hyping a stock was "Internet." Pets.com, one of many speculative dot-com companies, earned a gilded stock price of $11 per share in early 2000. Buoyed by an initial investment by Amazon.com, it ultimately raked in $300 million in early financing. Like many Internet companies in that era, however, it never earned a profit; when the bubble popped in late 2000, just months after Pets.com went public, the company announced its liquidation, driving shares down to 19 cents, a 98 percent loss. Today, the magic word for hyping stock could be "China."
A China strategy remains the holy grail for global companies. While China's growth has slowed from over 10 percent just two years ago to 7.6 percent in the second quarter of this year, executives still make their China strategy prominent in pitches to analysts and investors. Thirty-seven percent of companies surveyed from a range of industries consider China "critical to global strategy," according to an Economist Intelligence Unit report from November that surveyed executives from 328 companies. Forty-six percent expect China to be their biggest market within 10 years.
The conventional wisdom is that multinationals that successfully build market share in the fast-growing Chinese market will deliver profits that reward investors handsomely. Indeed, the success stories can be astonishing: Yum! Brands, which operates over 3,800 KFC restaurants in China and claims a 40 percent share of the fast-food market, received roughly 40 percent of its 2011 revenue and $900 million of its $1.8 billion operating profit from China. Boeing, which cites China as its biggest customer outside the United States, has a 52 percent share of China's commercial aircraft market; its business there is worth $4.8 billion, 7 percent of revenue. Nike, with revenues of over $2 billion in China and 16 percent market share in the country, reported in 2011 a Greater China operating margin (percentage profit before interest and taxes) of 38 percent, the envy of the corporate world.
But China is a much more difficult market than most company's stock prices reflect. In a May study by the European Union Chamber of Commerce in China, a business advocacy group, half the 557 member companies surveyed said that market access and unspecified regulatory barriers limited business opportunities and hurt annual revenues by 10 to 50 percent. The American Chamber of Commerce in China found similar results in its 2012 survey.
Many firms in industries the Communist Party deems sensitive -- such as oil, telecoms, and information technology -- hit a ceiling once their company expands above a certain size. Because reaching economies of scale fuels long-term success, constricting market share damps U.S. company prospects in China. Although there are individual exceptions, U.S. companies' share of the Chinese market has been shrinking. Industrial output by foreign-invested firms in China as a share of the national total peaked around 36 percent in 2003 and has declined ever since to about 27 percent in 2010, the most recent year for which data is available. The theft of sensitive technology, which leads to reduced market share, is also a concern. The technology firm American Superconductor claimed 70 percent of its business disappeared in 2011 after a Chinese partner convinced one of its employees to steal some of its technology. The November Economist Intelligence Unit report found that half the executives surveyed in big companies were concerned or very concerned they would be forced to give up their intellectual property in exchange for market access.
But the most unappreciated problem with investing in China is the unexpected risks that arise. "The government can close us down suddenly, or it can help native Chinese firms to steal our technology and gradually replace us in the market," says one U.S. CEO of his firm's China operation who asked to remain anonymous. Foreign assets also face the threat of liquidation. Although they're safe from Latin American-style government takeovers, China can de facto nationalize assets by exercising such strict control over taxes, regulations, and costs that it effectively controls and drains foreign firms' profits. Nearly 40 foreign electricity producers rushed into China in the 1990s, lured by long-term contracts with guaranteed returns. Today, nearly all these firms have since exited, often selling their plants to the Chinese after being unable to make money as rising coal prices outstripped electricity-rate increases set by the state and as Chinese firms benefited from access to state credit and subsidized coal. And though unlikely, China could descend into political instability or an armed conflict with Japan, the Philippines, Taiwan, or Vietnam -- a scenario in which foreign businesses would find it very difficult to operate. Such risks don't receive enough attention from analysts and investment managers. In its biannual country risk survey, Euromoney magazine optimistically gives China a risk rating of 61.5 points (100 being least risky), compared to 75.7 for the United States and a 53.7 for India.