A lot has been written about value investing. The success of its greatest follower, Warren Buffett, has elevated the investment approach to superstar status and it has become like a holy grail for profiting from stocks.

Pundits have jumped on the value bandwagon and their chorus has risen to a crescendo in harmony with Buffett-mania. So it was only a matter of time before their attention turned to Chinese listed companies.

Buy-side advice on Chinese stocks, listed in the US but generating income in China, is now on the web, often finding its way into email inboxes.

Some of the most inspiring advice eyes Chinese stocks through the lens of value investing. But is China different and can Western ideas fly on the Shanghai and Shenzhen A-share markets or more importantly, can it make money?

The aim of value investing is to, by means of fundamental analysis, find companies with good future prospects, but which have been undervalued by the market. Fundamental value analysis draws from a range of analysis tools, but the stereotypical symptom of a company with a low market valuation is a low price-to-earnings ratio. In this way it is possible to find and buy a stock trading at a discount to its intrinsic value and wait for the market to correct its mistake and drive the stock up to its real value.

Simply buy low, sell high, right? Not really. It takes hard work, deep financial understanding, great timing and most importantly, the ability to maintain a level head despite market speculation.

Shifting emotions

The value approach, first coined by Benjamin Graham and David Dodd in their seminal work "Security Analysis," makes a vital distinction between investment and speculation.

Wall Street Journal columnist Jason Zweig summarizes this distinction well in commentary in Graham's later book "The Intelligent Investor." "The market is quite efficient at processing the information that determines investment value. But predicting the shifting emotions of tens of millions of people is no easy task. So the speculative element in pricing is prone to huge and rapid swings that can swamp investment value," he wrote.

Looked at from another angle value investing can appear to be an important gauge for how well a market functions in pricing stocks, because this approach assumes a company's real value will eventually be reflected by its stock price. So the theory does assume the market is sometimes efficient in pricing stocks, but not all the time.

The problem here is whether the Shanghai Stock Exchange's A-share market is sometimes efficient enough to support value investing or if a high level of speculation tends to "swamp" value.

There are a number of indicators that suggest the A-share market will just chew up your value-searching money and, if that is true, will point towards an inefficient market system where company values are irrelevant to reality.

Firstly, the market has a large proportion of retail investors - some sources say up to two-thirds - and has been likened to a casino used for speculative gain by gambling investors. They constitute the "shifting emotions of tens of millions of people," as stated by Zweig.

According to Reuters, retail investors often ignore the fundamentals of the companies they invest in, instead many trade on day-to-day horizons, informed by speculation on macroeconomic policy trends, government industry incentives and whatever is popular in the trading halls.

Ben Cavender, associate principal at China Market Research Group, says there are a large number of people moving money around on the A-share market who do not necessarily understand how to accurately value a company.

"This makes it harder to look at a company's assets and business performance and directly correlate it to potential value investing opportunities because the stock may not perform as excepted.

"I absolutely get the sense that equities in China are not necessarily valued correctly. Sometimes it is too low. A lot of companies here see their stock prices suffer due to bad publicity when their business fundamentals are quite strong and on the other side of the coin there are plenty of companies that are seriously overvalued," he said.

Secondly, past experience has taught investors that policy changes can make or break a company in China. Government incentives can boost business prospects overnight and create new markets where there were none before, while bail-out money can resurrect state enterprises facing a certain financial death.

The opposite is also true. Government actions sometimes overrule company fundamentals and this tends to fuel more speculation on macro policies and causes overreaction to political announcements.

Thirdly, recent reports have exposed dodgy accounting practices by a handful of Chinese mainland companies listed in the United States.

Financial stability

This has cast doubt among foreign investors about the financial stability of Chinese companies and has lead to a mass sell-off in the US. This issue does not faze local retail investors who shun fundamentals and no similar sell-off has ensued on the A-share market. But for a serious value investor this poses a problem, because they depend on accurate company financials, among other things, to conduct fundamental valuations.

"There have been several instances lately of Chinese companies turning out to have misrepresented their performance and it is a big issue to consider when investing in Chinese companies," Cavender said.

"There is an attitude that because China has so much growth potential that any investment will turn to gold but many of these companies either do not have stringent accounting practices in place which lead to errors or deliberately misrepresent their performance."

So if the market is driven by emotion and mass speculation, is prone to large swings and the bulk of investors shun company fundamentals because they know they are probably erroneous or the government can wave a magic wand to rebuild fortunes, does this mean that value investing cannot work in the A-share market as true company value will never be realized?

The short answer is that value investing in Chinese stocks can work.

"The way to take advantage of China's megatrend is not to trade in and out of it, but to ride it on the backs of high-quality, innovative companies," said Tim Hanson from Motley Fool Global Gains. He recently traveled to China to uncover hot stock picks.

But Motley Fool, like other value pundits, has opted for companies on the B-share, Hong Kong or US markets as there is a perception that these companies are better regulated.

Still, you have funds making a decent living on the A-share market.

Cavender said investors have to be "relatively risk seeking" when placing money directly into Chinese stocks due to high volatility, high price-to-earnings ratios and the fact that companies are valued higher in China than they are on US markets.

"That is not to say that there are not companies with great investment potential listed in Shanghai, but one needs to conduct a lot of due diligence to confirm whether or not stated performance matches reality and most retail investors, and institutional investors for that matter, don't allocate the necessary time and resources to do so," he said.

"We expend considerable resources looking at performance from other angles, for example speaking with distributors, retailers, or consumers that buy a given company's product or service to get a clearer understanding of how a potential investment is operating.

Anyone who wants to try value investing or any kind of investing in China needs to do their homework."

Stricter controls

Hanson adds: "A local accountant told us that when he invests, he screens out any Chinese company that's reporting very high growth rates, because the companies with the highest growth are probably making it up." The good news is that it will be getting easier to do value investing as the A-share market appears to be maturing and stabilizing. Some even believe the fraud scandals in the US will turn out to be good for investors as it might lead to stricter financial controls in China.

"I would say that the A-share market is more stable in general than it was 5 years ago," Cavender said.

"More than anything it's just a growing process. Retail investors need to go through the experience of losing money while investing in equities to develop the caution needed to look at share prices rationally. For some investors here that has happened but there are a lot for whom that hasn't happened yet." That said, value investing is not a fool proof method. If it was easy everyone would have been a Buffett. It is easier to give in to human nature than go against the herd - and the herd is into speculation.

That will not change soon. The thrill of making a quick buck will keep the speculators alive and very active.

Nomura Research Institute Ltd recently estimated that common stock wholesale and retail brokerage revenues in China total US$14 billion compared with global wholesale brokerage revenues of US$40 billion from cash equity markets.

Who's making the most money between value investors and speculators?

Brokerages of course.

Michael van Zyl
Copy Editor of Shanghai Daily