HOW TO BET ON CHINA'S GROWTH
Hard landing? Soft landing? Here's the right strategy to invest in this tricky market for the long run.
(FORTUNE Magazine) – THAT CHINA IS THE WORLD'S MOST explosive and intriguing economic growth story has been blindingly obvious for some time. And the stories in this issue provide ample evidence that the dynamic expansion is in no danger of subsiding anytime soon. Such massive wealth creation is enough to pique the interest of most normal, red-blooded investors. Until, that is, you stop and notice that the country's two major stock exchanges, in Shanghai and Shenzhen, are down 5% and 10%, respectively, this year. Which raises a question: If you can't make money in China now, can you ever?
As we explained in our 2004 Investor's Guide last December, capitalizing on China's potential is more difficult than it looks (see "How to Play the China Boom" on fortune.com). For starters, there isn't always a connection between economic growth and gains in China's immature and relatively puny stock markets. "The Chinese economy overall is a macro-positive story," says Walter Hutchens, a China specialist and professor at the University of Maryland. "But the Chinese markets are the reverse."
In that regard, China isn't unique. Emerging markets frequently confound investors, says George Hoguet, emerging markets investment strategist for State Street Global Advisors in Boston. According to data he compiled, major indexes in Korea and Taiwan declined an annualized 0.08% and 3.5%, respectively, for the 15 years ending Aug. 31, a time of torrid economic expansion. Rapid growth in output doesn't always lead to big profit gains. And emerging economies are particularly sensitive to global shocks. "The big challenge for investing in any emerging market is translating superior economic growth into superior market returns," says Hoguet, who recently published a report on investing in China. Having said that, he continues, "The sheer size and scope of the Chinese market--both its economy and ultimately its stock market--is such that one can't ignore it."
THIS IS A TRICKY time in the Chinese markets. After roughly doubling in 2003, the major indexes cratered in the first half of this year amid Beijing's well-publicized efforts to slam the brakes on the economy. Officials cut off credit for industries like automobile manufacturing and steel, where the government saw speculative bubbles building. This prompted investor fears of a hard landing for the economy. China's IPO market, very active last year, slowed to a trickle--especially after the sharp decline in shares of many new issues. One notable example is insurer China Life, whose stock fell after reports of accounting irregularities at its parent company. In early September, Beijing called a temporary moratorium on new share offerings.
The government's efforts to keep the economy from overheating appear to be working, as forecasters now expect GDP growth to slow from 9.8% last year to closer to 8% next year. That's still amazing for a country of 1.2 billion people, but it's a decline all the same. "The long-term story is very compelling," says Timothy Moe, an Asia strategist for Goldman Sachs in Hong Kong who is currently predicting a soft landing for the economy. "Near term, however, there are issues, and we're on the wrong side of the cycle."
So if the climate is so challenging, why invest in China at all? The simplest reason is the size of the opportunity. "There are dominant themes that shape a decade," says Zachary Karabell, a fund manager of Fred Alger Management's newly formed China-U.S. Growth Fund. "Technology was the transformative factor of the 1990s. China will be the transformative factor of this decade. China touches everything else."
Then there's the simple contrarian argument: Others are bailing out, and that's often the right moment to pounce. Investment in the 22 China region funds tracked by researcher Lipper is a good proxy for U.S. interest in the country. New money flowing into those funds jumped ninefold in 2003 to more than $830 million as the major China indexes were soaring. Shortly after the markets started dipping in early 2004, money dribbled out, with negative flows recorded for four consecutive months beginning in April.
Before you put your chips on the table, however, it's important to know what you're buying into. The influential Chinese economist Wu Jinglian several years ago compared his country's exchanges unfavorably with casinos, saying that gambling dens at least are well managed. The exchanges were founded only about 14 years ago, primarily as a way for the government to begin selling off the lumbering state-owned giants of the communist economy. The stocks of these companies are referred to as A-shares, and even if you could buy them--they are largely reserved for Chinese nationals--you probably wouldn't want to. Regulatory controls haven't kept pace with the growth in listings, and the value of the 1,300 or so companies traded on the Shanghai and Shenzhen exchanges is only about $500 billion, roughly the market capitalization of General Electric and IBM. (There also is a class of companies available to foreigners as B-shares, but that market is worth just a small fraction of the A-share market and isn't all that popular as a result.)
The real action for foreigners in China stocks comes in three flavors. H-shares, traded in Hong Kong, are for mainland companies that satisfy the accounting requirements of the older exchange in the former British colony. Red chips are shares of Chinese companies that are incorporated in Hong Kong. And then there are N-shares, which offer a piece of Chinese companies traded on the U.S. and London exchanges.
Even finding quotes for China stocks requires learning a new nomenclature: A-shares, H-shares, and red chips have numbers instead of letters for tickers in Asia. Thus the melodiously named mainland cell-phone maker Ningbo Bird can be found on the Shanghai Stock Exchange at 600130.SS.
Given the myriad difficulties, the best way to approach China is still to invest through a specialized mutual fund, particularly one that broadens its portfolio by buying companies outside the mainland. Even this is not a perfect solution. Because of increased costs for research, banking, and legal fees, the expense ratio of the average China fund is 2.4%, vs. 1.5% for the average U.S. equity fund, according to Lipper.
But there are a few funds that have been standouts. One that we highlighted last December as a top performer is Dreyfus Premier Greater China (DPCAX). It carries a front-end load of 5.75% and an expense ratio of 2.25%. Over the past five years it has delivered an annualized return of better than 13%. Managed by Adrian Au of subadvisor Hamon Asset Management in Hong Kong, the fund seeks out midsized, under-researched companies. Of late Au is particularly focused on Chinese consumers who are suddenly able to spend their money on luxuries like fashion and travel. "Certain mainland tourists now can travel freely to Hong Kong," says Au. "This is a secular change."
His way of playing that shift is to go where the spending is, with Chinese retailer Lifestyle International Holdings (1212.HK) and Li Ning (2331.HK), an eponymous sportswear company founded by the gold-medal-winning Chinese gymnast. (The HK in the tickers means the shares trade in Hong Kong.) Au is also betting on increased energy consumption within China, and the country's need for more refineries and transportation infrastructure. For example, he owns Taiwanese construction engineering firm CTCI (9933.TW), which dominates the industry in Taiwan and has made inroads on the mainland.
Paul Matthews is the dean of U.S.-based investors in Asia. His Matthews China (MCHFX) has a relatively reasonable expense ratio of 1.71%, and it has managed an annualized return over the past three years of 18%. Of course, longer-term returns mask the volatility that China funds, and their shareholders, must endure. The Matthews fund, for example, was up 21% in 2001, down 8% in 2002, and up 65% in 2003. Says Matthews, whose holdings include telecom giant China Mobile (0941.HK): "You've got to take a long-term view because you don't know if you're buying at a short-term peak or a short-term trough."
Other funds take a more indirect approach to China, making Chinese stocks only one aspect of a diversified emerging-market strategy. One is Merrill Lynch Global SmallCap (MDGCX), which has a front-end load of 5.25% and a ten-year annualized return of 9.8%. The fund is managed by Ken Chiang, who has been following China since writing a thesis at Stanford in the 1980s on the country's modernization. One Chinese business he owns is Clear Media (0100.HK), a billboard company 48% owned by Clear Channel Communications in the U.S. Headed by a longtime Coca-Cola executive born in China, Clear Media has done a "massive land grab" in China, says Chiang. "All they've got to do is be there and grow with the GDP. It's one of the rare instances where you can make a straight investment on the Chinese economy."
Alger's China-U.S. Growth Fund (CHUSX) might be a good pick for the China investor who wants to take on the least risk. The Alger fund is only six months old, so it doesn't have a track record. But its approach is alluring. Half of the fund, managed by JF International in Hong Kong, is designed to behave like other China-focused funds, buying mainly H-shares and red chips. The other half, managed by Alger CEO Dan Chung and Zachary Karabell, aims to own multinational corporations that have made concerted efforts in China. "We felt a better way for investors to invest over time would be to diversify into non-Chinese companies focused on China," says Karabell.
Two such stocks that Alger owns are financial services powerhouse American International Group (AIG, $72) and fast-food giant Yum Brands (YUM, $41). AIG, founded in 1919 in Shanghai, expects China to drive much of its future growth. For example, it is one of several companies developing mutual funds for the domestic market with Chinese joint-venture partners. As for Yum, although China currently accounts for just 8% of KFC's worldwide locations, the company's business in China (including Pizza Hut) already accounts for almost a third of its earnings growth.
Soon there will be an alternative to actively managed funds. Until now U.S. investors wanting a low-cost way to passively invest in China's market--the equivalent of an S&P 500 index fund--have been out of luck. But in October, Barclays Global Investors is expected to launch a new exchange-traded fund called the iShares FTSE/Xinhua China 25 Fund. Linked to an index of liquid, large-cap stocks of mainland companies, the fund will list on the NYSE with an expense ratio of 0.74%. For investors looking to bet on China's long-term prospects, it might well be the most efficient way to make the wager.