Playing the China boom
It's not too late to buy into the Asian giant's stock rally. Just be prepared for some whiplash.
(Fortune magazine) -- It happens every weekday: A group of ladies gathers at the cavernous, badly lit stock-brokerage office on Shanghai's Xiangyang Lu in what was once, when China was colonized by European powers last century, known as the French Concession. There are usually at least four, and sometimes as many as eight.
Retirees all, they come with tea and nuts and candies to snack on. They plop down at a table in the main hall and watch the electronic stock ticker board above them track the day's activity. They trade gossip, peruse a few business papers, and discuss investment ideas.
These stock-crazed seniors capture the mania -- the obsession, some would say -- that is the investment game in China. Even though the ladies are all over 60 and are playing with relatively small sums of money, they are really traders, not investors.
They buy and sell frequently, often on the flimsiest of rumors. "Everyone knows," whispered Hong Feng, a former schoolteacher, conspiratorially to a friend in early November, "that the government wanted the stock market to go up this year. But now they think it might be getting too hot. It might be time to sell."
Well, everyone may or may not know what Beijing's central planners want. But when it comes to the global economy, this much is true: 2009 was China's year. In the face of a brutal recession in the developed world, China powered ahead, posting unexpectedly brisk economic growth on the back of government stimulus and a huge increase in bank lending.
And China's stock markets in Shanghai and Shenzhen responded. By late November the so-called A shares -- which account for the vast majority of stocks traded and are open only to investors in China -- in each city were up 70% and 105%, respectively.
The MSCI Broad China index, which tracks a composite of Chinese companies that foreigners can invest in from Hong Kong, New York City, and Taiwan, had risen 66% by the end of November.
Throw in a 2010 economic outlook that looks just as strong, and everyone again wants a part of the China growth story next year.
Set against that enthusiasm is the widespread perception that China's markets trade less on rational factors -- like how much a company will earn over time, discounted for inflation -- and more on the rumors and gossip that the ladies of Hong Feng's group love to parse every morning.
So before assessing whether and where to invest in the China story in 2010, it's important to understand the dynamics at work.
There's no getting around the fact that China's domestic equities market is still immature -- and highly volatile. There are several reasons for this.
Remember that most stocks listed in Shanghai and Shenzhen are open only to Chinese investors (though foreigners can invest directly in a more limited number of companies through the thinly traded B share class).
Meanwhile the Chinese -- with their famously high savings rates -- have limited opportunities to put their money to work abroad. So the homegrown market is effectively a closed shop.
Banks pay almost no interest on deposits in China, which pretty much leaves equities and real estate as the two main investment options for retail investors. And institutional fund management is still very small.
So rather than being guided by large shareholders that crave stability, the stock markets are dominated by skittish amateurs.
Put it all together, says Francis Cheung, chief strategist at CLSA Securities, an Asia-focused research firm, and you have an environment where "people do tend to get whiplashed. It's not yet a buy-and-hold market."
Indeed, talk about violent reversals: At their peak in 2007, Chinese stocks in Shanghai and Shenzhen traded at a stratospheric 50 times earnings before declining in value by more than 60% in calendar 2008.
That volatility inevitably translates to the Chinese equities that are readily available to foreigners -- through either direct listings in New York or Hong Kong or the many actively managed China mutual funds and ETFs.
But the good news, says Cheung, is that the names that trade in Hong Kong or New York "tend to trade more efficiently than the market in China." In part that's because they are typically the higher-quality names, with relatively transparent accounting.
It's also because those markets are highly competitive. When Shanghai and Shenzhen traded at 50 times earnings, the MSCI Broad China index was at 20.
What's the smart way to approach such a high-risk, high-reward market? Start with the macro outlook, where it's clear that what you see is what you get.
Chinese authorities have thrown the kitchen sink at the economy in 2009 to keep it afloat and "are determined to do so again in 2010 and beyond if necessary," says Henry Chan, who manages the Greater China Fund for Barings Asset Management.
There's a lot of chatter about whether China is or isn't reinflating two bubbles (real estate and equities). But bear in mind this critical point: If in the U.S. the tried-and-true axiom is "Don't fight the Fed," in China it is "Don't fight the State Council" (the highest domestic policymaking body, to which the People's Bank of China reports).
Loan growth from China's state-owned banks increased 30% year over year in 2009, and the government has indicated that it will slow only gradually in 2010, to a targeted rate of about 20% growth. At the same time the government's stimulus spending will continue apace in 2010, further boosting construction companies that have been riding the boom this year.
Not only is growth in China accelerating, but exports are also beginning to pick up as the global economy gets off the deck. And there is still no inflation threat visible. (Indeed, Beijing continues to report deflationary price activity.) The bottom line, says Chan, is that the growth will flow through to corporate earnings in 2010.
That doesn't mean foreign investors should buy indiscriminately. At 14 times forward earnings, Chinese equities are "not expensive, but they're not supercheap either," says CLSA 's Cheung. Nearly all analysts agree on the major themes that ought to work in 2010. The biggest? No surprise: more infrastructure. That means that material stocks should continue to ride high.
Consider General Steel Holdings (GSI), which trades on the New York SE . The company -- which, as CEO Henry Yu says, is in the business of helping "consolidate via acquisition and joint ventures" the Chinese steel industry -- is benefiting from the huge infrastructure build-out in and around Xi'an in central China. It also in November completed an acquisition of Tangshan Baotai Iron & Steel Group that should expand its geographic reach into northeastern China.
According to Standard & Poor's, analysts expect GSI to earn 14¢ a share this year. But in 2010 the consensus is that its earnings will soar 190%, to 90¢.
The stock has moved up this year to just over $4 from a 52-week low of $1.84 last spring. But if it can deliver that projected earnings increase next year, it should have plenty of room to move higher.
The other major theme that nearly every China analyst now pushes is consumption growth. Cars, appliances, consumer electronics, and apparel have all either boomed in 2009 or shown signs of recovering as the economy gains steam.
The difficulty again, as Chan says, is to be selective, because a lot of these stocks have run up this year. Still, a basic thesis is that urban Chinese have money, they aren't in debt like their American brethren, and they are buying things they didn't used to -- such as life insurance.
Chan of the Greater China Fund (GCH) is bullish on the nation's insurance business, and one name that stands out is Ping An (PNGAY), which trades over the counter in the U.S. and in Hong Kong (HKG: 2318). Its share price has more than doubled this year, and its multiple is steep, so you might want to wait for a dip. But Ping An has undoubted earnings momentum going into 2010.
In fact, if there's one word to describe China heading into 2010, it's momentum, and a way to capture that generally is to buy Chan's fund, which is up 62% in 2009 and has averaged a 20% total return over the past five volatile years. In 2010 the message from China is straightforward: Go with the flow.