March 2004 / No. 28

Stock Exchange

How to Play the China Boom

Investing in China ought to be a no-brainer. With an economy that has barreled forward at an average rate of 7% for five years running and that will probably advance 9% in 2003 despite SARS, China boasts the world’s most compelling growth story. As it rises, China is roiling markets everywhere—driving up the price of commodities from copper to gas, sucking in billions of dollars of investment from foreign multinationals and fanning protectionist sentiment in Washington, Tokyo, and Brussels. For all appearances, China’s transformation from communist backwater to manufacturing powerhouse is a mega-trend right up there with the Industrial Revolution.

Little wonder, then, that institutional investors are clamoring for China stocks. Or that Warren Buffett, breaking with his penchant for investing close to home, plunged into China this year, acquiring a 13% stake in China’s largest company, state-controlled oil giant PetroChina. But individual investors should think twice before seizing the China bull by its horns. The smarter approach is to dance around it—investing broadly in commodities, for example, or better yet, a well-managed fund that holds a mix of businesses incorporated in and outside the Chinese mainland. Why be cautious? China’s equity markets are immature, fragmented, and susceptible to speculative mania. Executives are governed by imperatives that bear scant resemblance to those driving counterparts in full-fledged market economies. And Chinese stock prices are a poor proxy for the strength of the economy.

“One of the first lessons you learn about investing in China is that a good economy doesn’t necessarily translate into a bull market for China stocks-and vice versa,” cautions Cheah Cheng Hye, chief investment officer for Value Partners, a Hong Kong investment firm with $1.6 billion under management. “Some of the best Chinese companies aren’t even fisted. And it’s easy to get stuck with a lousy company that isn’t benefiting.”

It’s tempting to dismiss such counsel given the phenomenal performance of many China funds this year. The four that Cheah manages, for example, have rung up year-to-date gains of between 70% and 100%. According to Lipper, the fund research firm, all 22 China equity funds available for purchase by U.S. investors reported returns of at least 29% for the year through early December; five were up more than 57%. The Bank of New York’s China index, a composite for shares of 25 Chinese companies traded on New York exchanges as American de­positary receipts, has climbed 55% for the year, while the broader MSCI Golden Dragon index has risen nearly 40%.

Still, fund managers are wary. “All the noise about China lately has gotten investors very excited, but I fear there’s been too much hype,” says Mark Bree­don at Investec Asset Management in London. “We feel the conceptual story for China is a posi­tive one. We’ll get to the Promised Land eventually. But it’s going to be a very bumpy ride.”

Since Chinese companies began offering shares to the public in the early 1990s, China investors have been buffeted by no fewer than three major market crashes and engulfed in a constant swirl of tiny bubbles. Of the top ten China regional funds as ranked by Lipper, all but three had negative returns in 2000, 2001, and 2002.

Skeptics tick off a host of reasons China stocks may be headed for another dive. Some fear China’s economy has been growing too fast in recent months and is due for a painful adjustment. Others fret that in a U.S. election year, simmering resentment of China’s rising exports could boil over into a trade war. Or per­haps Beijing will be tempted to defuse tensions by allowing its currency to strengthen, squeezing ex­porters. “Buying China shares was a great idea a year ago, and now it’s not,” says Andrew Ballingal, founder of the Hong Kong investment fund that bears his name. “At this stage in the cycle, I don’t see much out there that’s attractively priced.”

Such caveats shouldn’t deter long-term investors, says Edward Mullen, managing director of Dynasty Asset Management in Shanghai. “Sure, there’s going to be choppiness,” he says. “But we’re talking about an emerging superpower here, and the momentum is tremendous”. My view is that every investor in the world should own a little piece of China. I’m not saying it should be 50%, or even 5%, but you should at least have some exposure.”

Maybe so. But how should you place your China bets? Even the most intrepid gamblers may be put off by the bewildering array of options. China stocks trade in an alphabet soup of different classes, across a hodge-podge of competing exchanges. Most com­panies listed on the Shanghai and Shenzhen bourses offer class A shares, denominated in yuan and large­ly reserved for mainlanders. A small group of main­land companies offer class B shares, denominated in dollars and intended for foreigners. H shares, traded in Hong Kong, are issued by companies incorporated on the mainland but satisfying the stricter require­ments set by regulators in the former British colony.

And of course they differ from so-called red chips, shares offered by the Hong Kong-incorporated affil­iates of mainland entities, and mustn’t be mistaken for the mainland companies that trade as depositary receipts on exchanges in New York City and London.

Confused? If so, it pays to remember China’s equity markets were born of socialist expedience, not of a desire to fatten your retirement nest egg. Disci­ples of Communist leader Deng Xiaoping launched stock exchanges in the early 1990s as a social exper­iment. As part of his tilt toward a market-oriented economy, Deng had directed officials to scale back subsidies to inefficient state-owned enterprises. But planners could turn only so many workers out on the street, so they temporized by propping up fail­ing entities with loans from state-run banks, Soon banks were buried in unrecoverable loans, and Beijing turned to equity markets as a fallback corporate welfare net.

China’s exchanges have expanded rapidly. Today the two mainland bourses boast more than 1,200 listed companies and have a combined market capitalization of more than $500 billion. The new headquarters of the Shanghai Stock Exchange, built at a cost of $100 million, bristles with 5,700 trading terminals and 30,000 fiber-optic telephone lines.

The hardware is modern, but the companies are Jurassic. State-owned dinosaurs dominate exchanges; more nimble private firms are kept out for fear they’ll siphon capital. Chinese investors have clamored for equities all the same. And why not? Banks pay paltry interest rates, and Beijing bars individuals from in­vesting overseas. By 2001, an estimated 40 million Chi­nese had purchased shares. From Shanghai to Xinjiang, market watchers crowd the lobbies of brokerages to peer at electronic stock boards and swap market gossip. Some of the keenest investors are laid-off work­ers, desperate to stretch their pensions. Stained un­dershirts or pajamas and slippers are standard attire.

The market has boomed faster than Beijing’s ca­pacity to regulate it. And because individuals hold more than 90% of all outstanding shares, China has few institutional investors powerful enough to im­pose order or force companies to pay higher returns. Since their 2001 peak, A shares have slumped about 40%, as embittered investors shunned exchanges rife with insider trading, price manipulation, and fraud.

Foreign institutions could help bring discipline to China’s markets—not to mention loads of cash. But authorities remain wary of relinquishing control of big employers and worry about “hot money” flows of the sort that toppled a government in Indonesia during the Asian financial crisis of 1997-98. So they have been opening markets little by little. Non-Chinese investors have never had much use for B shares, the stocks originally invented for them; this motley and illiquid collection of about 100 companies consists mainly of unprof­itable state-owned entities riddled with debt. But this year, for the first time, Beijing granted foreign in­vestors the right to bid for A shares under a new pol­icy for qualified foreign institutional investors (QFII). For now, QFII has daunting limits. To participate, fund managers must command at least $10 billion in assets. Investors must hold stocks they purchase for at least a year. And they can only repatriate profits in 20% increments over a period of many months. So far ten investment houses, including Goldman Sachs and Morgan Stanley, have won licenses. But regula­tors are capping combined foreign purchases to less than $900 million—barely one day’s turnover.

The right to purchase A shares might seem a du­bious one, given that they trade at an average of more than 40 times earnings. H shares trade at multiples of about 15. In theory foreign investors should find top values in Chinese companies whose shares trade on exchanges outside China. These are supposed to be the crème de la crème. But they have proved fickle performers. The Hang Seng China enterprise index, which tracks H shares, is up 104% this year, ap­proaching a five-year high but still well off its peak. Most H shares trade below their IPO values.

Experts pale at the suggestion that small investors emulate the Sage of Omaha by loading up on shares of a single company. “The last thing you want to do in this market is put all your chips on one or two stocks in the hope of finding China’s IBM,” says Geoff Lewis, head of investor services at JF Asset Management in Hong Kong. They also warn against following a broader index. Too few China shares trade on over­seas exchanges to build a balanced portfolio. China’s two state-run oil companies, PetroChina and Sinopec, constitute roughly 40% of the market capitalization of the H share index. A handful of telecom providers account for much of the rest. Investors win be able to choose from a wider range of China stocks in years to come, as Beijing allows more firms to have overseas IPOs. Dozens of Chinese firms are planning such of­ferings for the year ahead. First in line: China Life In­surance, which hopes to raise more than $2 billion in Hong Kong and New York.

For now, most experts recommend purchasing “greater China” funds rather than buying China shares directly. Typically, such funds include not only the shares of Chinese companies traded overseas but also non-mainland companies with substantial in­vestments, supply networks, or markets in China. At Matthews China fund the largest holdings include H shares like Denway Motors, the Guangdong joint ven­ture partner to Japan’s Honda Motors, and Tsingtao Brewery, the first mainland company listed in Hong Kong. But among its other top picks are Shangri-La Asia, a Hong Kong hotelier controlled by a Malaysian property tycoon who secured the right to develop a string of five-star mainland hotels. Dreyfus’s four China-related funds all count among their top hold­ings Li & Fung, a Hong Kong firm that coordi­nates supply chains linking U.S. and European retailers with mainland producers.

Notably, Chinese funds scoring some of the largest gains this year have eschewed mainland shares for old-fashioned Hong Kong plays—­companies like property developer Cheung Keong Holdings or Hong Kong Shanghai Bank, where main­land interests don’t drive strategy. Says Value Partners’ Cheah: “We’re unwilling to compromise invest­ment discipline just for the sake of getting into China.” For now Cheah sees “few bargains available in the markets for China-related stocks.”

Well-heeled investors looking primarily for China stocks might want to consider Mullen’s Dynasty fund. Established three years ago and opened this year for public in­vestment, Dynasty is a relative new­comer to the China game, but its strategy is yielding impressive re­sults. Mullen insists any fund seri­ous about making money in China ought to be based there and staffed by Chinese pro­fessionals. Dynasty sticks to firms for which China is an integral part of overall strategy. Mullen believes the best way to manage risk is to offset bullish in­vestments in some companies with short positions de­signed to capitalize on share-price declines in others. Dynasty has invested in auto and energy companies, but it’s betting against China’s two cellular providers, China Mobile and China Unicom, because the gov­ernment is granting licenses to six new carriers. Last year, says Mullen, Dynasty earned “about half our profit on the short side.” Since launching in 2001, Dy­nasty, with $100 million under management, has reaped average annual gains of 54% and a cumula­tive return of 226%. Not bad, but there’s a catch: the minimum investment is $1 million.

Those in search of a lower ante might consider China Fund Inc., which trades on the NYSE-mean­ing U.S. investors can get a piece of the action sim­ply by ringing up their broker and buying shares. Though managed by Scotland’s Martin Currie, the fund’s investment strategy, like Dynasty’s, is set in Shanghai. Fund director Chris Ruffle says mem­bers of his crew visit 800 companies a year and aren’t allowed to recommend any mainland concern “unless we’ve walked the factory floor.” The em­phasis is on smaller firms where “management has a significant stake in company performance.” With $265 million invested in about 50 companies the fund boasts an average annual return of 21% over the past five years, compared with -1.4% for the MSCI Golden Dragon index.

Stocks aren’t the only way to hitch your wagon to China’s shooting star. Some mavens tout commodity futures. Surging demand from China has pushed up global prices for a host of materials, including alu­minum, coal, cotton, nickel, petroleum, palm off, and steel. But Marc Faber, an early proponent of that strat­egy, now worries it’s been overdone. “If industrial pro­duction and fixed capital investment slow down, the rate of increase in the demand for commodities will suddenly diminish,” he noted recently in his newslet­ter. “Or worse, Chinese demand could even tem­porarily decline.” Alas, for now, predicting Chinese growth remains a lot easier than profiting from it.   

Courtesy of Fortune Magazine, Dec. 22, 2003