How Much of China's "Earnings" are from Operations?

I wrote over the past few months a few entries about how some? (much?) of earnings that are rising in Shanghai are not based on actual operations but instead investment gains. So while a 50 PE ratio can be explained away as "the price for such high growth" (which is nonsense), it is even more nonsense when you understand that some portion of these profits are not from operations but simply stock investing/speculation. This works great, until the trend reverses - and then (as this article from BusinessWeek points out), you have to book those losses, which generally will drive your stock down, which eventually causes a cascading effect....

While hard to quantify the exact amount, here are some figures:

• Companies big and small are now playing the markets with abandon, using corporate funds to invest in each other's initial public offerings and bolster their bottom lines. Although figures are hard to pin down, Morgan Stanley figures a third of reported corporate earnings in China stem from investments outside companies' core businesses—which in almost all cases means plowing money into stocks.
• "It's quite dangerous for these Chinese companies because these gains have no cash basis," says Ding Yuan, a professor of accounting at China Europe International Business School in Shanghai. "It's really frightening."
• If and when stock prices start to fall in earnest, companies will have to report these portfolio losses on their income statements, depressing their earnings. That, in turn, could hurt their own stock prices, pushing the market down both further and faster.
• "It's a replay of what happened in Japan during their bubble," says David Webb, a Hong Kong-based corporate governance expert and non-executive director of Hong Kong Exchanges & Clearing. Japan Inc. gorged on stock and real estate, only to tumble into the red when those markets collapsed.

Now, I love the following example in which the company says investment gains are just a 'supplement'.... a supplement to the tune of 98.5% of earnings? Ahhhh...

• To see how big an impact investment income can have on earnings, consider the Youngor Group, which has some $800 million in annual sales. Since the garment maker was founded in 1979, Ningbo-based Youngor has grown into one of China's top-selling apparel brands.
• But these days those operations pale in significance beside its stock portfolio. Youngor's holdings include shares in China Life (LFC), Bank of Ningbo, and Citic Securities, the country's largest broker and a red-hot stock in its own right. Gains on these shares helped Youngor book $223.6 million in investment income for the first nine months of the year, accounting for 98.5% of overall earnings.
• A member of Youngor's investment department, who requested anonymity, downplays the investments as "just a supplement."

That's just one random company, now for the aggregrate estimates

• Wind Info of Shanghai, which provides financial data on listed companies in China, estimates that as of June 30, 494 listed companies had stock market holdings worth $45.6 billion, vs. $2.3 billion held by 163 companies a year earlier. Morgan Stanley figures "noncore" earnings from stock, real estate, and other ventures accounted for 54.1% of profits in China's health-care sector and 64.6% in the consumer goods sector.
• In China, few investors possess the ability to comb through financial statements and distinguish a company's operating earnings from its stock plays. "People overestimate Chinese investors' sophistication," says Jerry Lou, head of China research at Morgan Stanley (MS). "Somebody needs to point out that the emperor has no clothes."
• Professor Ding cites the case of Black Peony, a textile company, as an example of what happens in a hot market. In the first half of this year, Black Peony recorded profits of $5.8 million, almost all of it from gains in shares like Air China, dividends from other stocks, and payouts from affiliates. Meanwhile, its core textile business is struggling. "They're not controlling any costs because life is easy," says Ding.

Anyhow, this is but just flashing warning signal. Aside from stories like this, basic 'greed' which is a human trait, outside of any nationality or race is going to be another downfall, once it is revealed. When you see new found riches all around you so easily 'created' out of thin air, this can only tempt many others to do whatever they can to also reach for this pot of gold. We saw this gold rush mentality in the Japanese market in the 80s, tech stocks late 90s, and most recently our astute and conservative (and full of great financial innovation) financial institutions, which we will all pay for this time around, not just the 'investor class'. Be sure it is happening in China as we speak - it's just a matter of when the proverbial fertilizer hits the fan... as I stated many times it is far too easy to say "invest until the Olympics, everything is safe until then". When everyone believes something it is never the end result; either the market has a major shakeout well before the torch lights up next summer or the bubble will continue far past the closing ceremonies. The thing that makes it so hard to call is the enormous liquidity running through the system... sort of like another country I know of, but for totally different reasons (i.e. printing money here, versus huge trade surplus there)