Investing in China

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Investing in China: 11 Reasons Why & 5 Ways to Buy

by Louis Basenese, Advisory Panelist, Investment U
Associate Investment Director, The Oxford Club
Wednesday, January 14, 2009: Issue #915

It’s time to make a big bet and begin investing in China.

I know. It’s not exactly a popular stance. And the smart money is doing exactly the opposite. Or so it appears…

Yesterday, the Royal Bank of Scotland hit up the China ATM for a $2.37 billion withdrawal. It sold its entire 4.3% stake in Bank of China. And a week ago, Bank of America cashed out part of its stake in China Construction Bank Corp. for an estimated $2.83 billion.

Making matters worse, the MSCI China Index lost a record 53% last year. It’s counter-intuitive and near impossible to rationalize adding money to a losing investment…

Investing In China – 11 Reasons Why It’s Time

Here are 11 reasons why investing in China is exactly what we should do:

The truly “smart money” is buying, not selling. To be fair, the reason Bank of America “took a little money off the table,” according to spokesman Bob Stickler, is because of its own financial condition and need to raise cash. Same goes for the Royal Bank of Scotland. Yet, looking past these institutions, the truly smart money is loading up on China. Mark Mobius, the king of emerging markets, sums it up best, “We’re having a wonderful time buying tremendous bargains.” Stats from research firm EPFR indicate the rest of the smart money is following suit. Funds investing in emerging-market stocks raised their Chinese holdings to the highest level since 1995. We should, too.

Chinese stocks are cheap. Ridiculously so. If legendary investors like Warren Buffett salivated over U.S. stocks trading at 12 times earnings, they should be rabid over Chinese stocks. Based on the MSCI China Index, the average Chinese stock trades for less than eight times earnings.

Share prices are contracting, but earnings keep growing. Based on the severity of the sell off, you’d think every Chinese company was unprofitable and headed for bankruptcy. Yet the fundamentals remain rock solid. The average Chinese company is still growing earnings by 30%, according to a recent report in China Securities Journal. Compare that to the estimated 12% earnings decline in the fourth quarter for the companies in the S&P 500, and the bargain valuations make even less sense.

Chinese investors learned a tough, but necessary, lesson. During the height of China’s economic boom, retail investors viewed the stock market as an ATM. They lined up by the millions to open brokerage accounts. But much like our infamous dot-com bubble, Chinese day traders and novice investors got a very painful reminder of what happens when the “Greater Fool Theory” reaches the last idiot. The important thing, however, is that the correction served a higher purpose. It began the process of flushing the extreme irrationality from the market. So we can be certain the next leg up will be governed by fundamentals, not hype.

Oil is much cheaper. One of China’s biggest challenges was to keep a lid on inflation, while still maintaining its breakneck pace of economic growth. That was no easy task with oil at $150 as the cost of shipping, food and fuel were increasing rapidly. Keep in mind, China imports a net 3.3 million barrels of oil a day. Now that oil prices are down considerably, we can cross one big inflation risk off the list.

The economy is NOT in a recession. Sure, it’s slowing down, but China is still on track for a solid 6% expansion based on analysts’ estimates. And 8% if you believe the government statistics. Regardless of who ends up being right, compared to the contraction in the United States, such a rate is downright explosive.

Massive foreign reserves. The last time Chinese stocks were this cheap was during the Asian financial crisis. Back then, most Asian countries were running huge deficits. But this time the roles are reversed. As of December, China boasts $1.95 trillion in foreign reserves. And counting. If necessary, the government can deploy these surpluses to keep economic growth humming along.

Personal savings. Unlike Americans that spend more than they earn, the Chinese save an amazing 35 cents on every dollar. This provides yet another cushion against any slowdowns. But also an enormous opportunity for future growth. As China’s economy develops, and affordable insurance and health care become ubiquitous, expect the Chinese to get comfortable spending more of their hard earned cash.

The consumer is just getting started. The country’s burgeoning middle class, now the size of the entire United States, is just getting started. The McKinsey Quarterly estimates that it will take two decades before these nouveau riche reach their full spending potential. As we know from our own experience and prosperity – 70% of GDP in the United States is attributed to consumer spending – the consumer is an engine of economic growth. In other words, the global recessionary headwinds are no match for the Chinese consumer.

Forget what Westerners think, locals are optimistic. We know consumer confidence plays a big role in the success of our own economy. It flat out stinks right now in the United States, And the economic conditions reflect it. But in China, it’s an entirely different situation. A recent survey from the Pew Research Center shows that most Chinese (86%) feel positive about where their country is headed. And that’s up from 25% just six years ago. If they overwhelmingly see good things on the horizon, we should believe them.

The “mother of all stimulus plans.” While the massive government stimulus package has yet to take hold in the United States, rest assured it will. Same goes for the $584 billion the Chinese government is pumping into its economy. As a fund manager for BlackRock notes, China’s “got the mother of all stimulus plans” when you factor in the government spending, savings rates and the rapid decline in commodities prices.

Investing in China: 5 Ways to Play It

Make no mistake. The shooting fish in the barrel stage of investing in China is long over. Simply buying the iShares FTSE/Xinhua China 25 Index ETF (NYSE: FXI) won’t cut it anymore. It’s too obvious.

So how do we play the next bull charge in China?

Well, last week, I offered up one compelling small-cap Chinese play, E-House Holdings (NYSE: EJ). I’d stick to that theme – small caps, with the strongest growth profiles. And that puts China Security & Surveillance (NYSE: CSR), a leading provider of digital surveillance technology, and A-Power Energy Generation Systems (Nasdaq: APWR), a power equipment company, at the top of my list.

For those with a more conservative bent, I’d stick to large-cap, blue chip, best-of-breed China stocks. Ones like China Mobile Ltd. (NYSE: CHL), the world’s largest phone company. It sports a sold balance sheet, increasing profitability and a temporarily cheap valuation.

Whatever you do, don’t wait too long. The Chinese New Year holiday gets underway January 25. When it’s over, don’t be surprised if the Chinese markets start fresh and get back to their winning ways.

And I say that because the strong economic underpinnings, which lined investors’ pockets with gold from 2004 to 2007, remain well intact. Whether the next leg up will produce the same 450%-plus returns remains to be seen. But rest assured, the catalysts are in place to make it possible.

Good investing,

Lou Basenese

Editor’s Note: These aren’t the only China-plays Lou recommends. In fact, he recently profiled his two favorites for investing in China for Oxford Club members. One surged 144% following the last downturn, coming out of the Asian financial crisis in the late 1990s. And he believes it could easily do the same, or more, this go-round. To find out all the details, sign up for The Oxford Club. Then check out the recent portfolio updates.

Today’s Investment U Crib Sheet

Having the proper mix of domestic and international stocks is important for balanced asset allocation. We recommend 30% of your portfolio contain foreign stocks. Find out more on asset allocation and how you can reduce your risk and improve you returns with Investment U’s Asset Allocation Model.

We’ll continue to provide you with actionable information on all components of our asset allocation. Recently, we’ve touched on domestic stocks and REITs.

Lou Basenese has been giving us multiple ways to play the emerging small-cap sector. But as he’s documented, these companies move the fastest and most unexpected. Once they start climbing, it’s already too late. Four “small” ways to get in now can be found in Investment U Issue #911, Small-Cap Investing: How to Play The Emerging Small-Cap Rally.

Last week, Robert Williams gave us a handful of “bulletproof REITs” that aren’t just surviving, they’re profiting – in a sector that’s been crumbling under the weight of the credit crisis. To find out more about one of the only REITs profiting from mortgage-backed securities, check out Investment U Issue #912, Bulletproof REIT Bargains: How to Profit From the Inevitable Real Estate Recovery.