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On my latest appearance on CNBC's "Capital Connection," with Chloe Cho, one of the hosts asked me if Western investors should invest in China right now. I may have surprised many who know I think China is the growth story of the 21st century. I said retail investors should think twice about investing directly in Chinese companies listed in the U.S. and might be better off not investing unless they can stomach real risk.
Why? First, Chinese company stock prices remain very volatile, because of hedge funds. There are only several dozen good Chinese companies traded on the New York Stock Exchange and NASDAQ, so hedge funds control an inordinate amount of Chinese equity. If they grow bearish or need liquidity, they might sell stakes quickly. Second, despite some improvement, the transparency of Chinese firms remains questionable. My firm, the China Market Research Group, once conducted due diligence on a publicly traded firm for a client who wanted to invest $50 million. We found that the company was booking as revenue deals that had not been signed but that potential clients had orally promised years before. Many Chinese companies keep three sets of books, one for the tax bureau, one for investors and one for senior executives.
Aside from business risk, never underestimate the political risk inherent in much business in China. For instance, I told the anchor I was not overly optimistic about Agricultural Bank of China's initial public offering or about investing in other state-owned enterprises, because they are more political tools than true profit-seeking ventures
What is good for the economy is not necessarily good for investors. One reason China's economy remained robust during the Great Recession is because Bank of China and ICBC loaned money under central government direction to get liquidity into the system. That was undoubtedly good for the economy, but it wasn't great for investors who will have to deal with years of rising non-performing loans. Also, senior executives at large state-owned banks care more about jockeying for political power than making money. Most of China's senior central bankers previously worked in the big state-owned banks, and many have even been rotated between banks by government appointment. Imagine if President Obama directed Lloyd Blankfein to leave Goldman Sachs ( GS - news - people ) to work for Morgan Stanley ( MS - news - people ) for a few years before moving to Bank of America ( BAC - news - people ) and then replacing Ben Bernanke at the Fed.
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In order to stave off high gasoline prices, the government could force the oil giants Petrochina and Sinopec to freeze prices at the pump, even if it killed their margins. It is true that sometimes the government will want state-owned enterprises to make money, but if you invest in them you need to be a political expert more than a business analyst.
Even when investing in private Chinese companies you need to take politics into account. A sudden morality campaign by the government might mean shutting down things like micro-blogging sites without warning, or imposing limits on online gaming (gaming addiction among youngsters is increasingly being viewed as a serious social problem). That would hurt the stock prices of online game companies like Netease, Shanda and Sohu.
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