A look Into China's Investment Environment
Everyone agrees that the Chinese economy is growing fast. Where there is a wide difference of opinion is on the ability of corporate China, and especially investors in it, to continue to benefit from that growth if it slows a bit, or even if it does not. Concerns exist about economic conditions worldwide as well as a bunch of local issues. The list includes the outsized impact of high commodity prices on the heavily industrializing economy, the work in progress that is Chinese financial and economic regulation, and the imminent coming and going of the Beijing Olympics.
The route traversed by the Chinese stock market during the past year shows just how uncertain the future appears to investors. Major indexes were cut nearly in half between November and March, then experienced a significant bounce, coinciding with the recovery of stock markets globally. It remains to be seen whether the recent action represents the resumption of a long bull market after a death-defying correction or a bulltrap rally within a popped bubble. The consensus, what little there is of one, is that the path of least resistance leads down; investment advisers express extreme caution about China, although the source of their anxiety varies.
Hugh Young, head of equities for Aberdeen Asset Management, sees trouble brewing. "Rampant inflation risks are creating havoc with company earnings," Young said. "We pared our positions in the strong market last year and are not desperate to reenter. We're still very wary of China."
So is Thomas Mengel, manager of the Ivy International Growth Fund, and for much the same reason. China is such an economic juggernaut that tepid growth there - an annual increase in gross domestic product, adjusted for inflation, of 8 percent to 9 percent, would amount to astounding strength almost anywhere else. While Western companies are used to the ups and downs of the business cycle, in China they seem to know only ups and ups, leaving profits that are highly dependent on unrelenting economic progress.
"We have sold down our Chinese stuff," Mengel said. "We fear that if China were to slow down a bit, the margins of many companies could get squeezed quite significantly. The market has become more sensitive to that, and we're a little bit more defensive."
Even a relentlessly and rapidly expanding economy is no guarantee of corporate or investment success, Alexander Muromcew, a manager of Asia portfolios for TIAA-CREF, pointed out. "China is always a tricky stock market," he said. "There is often a disconnect between the wonderful headline GDP numbers that we see and the ability of foreigners to make money in Chinese stocks."
The market suffers from "an opaque regulatory environment and issues with management quality and corporate governance," Muromcew said. He noted that many listed companies were once state-run enterprises, where the objective often was to employ people rather than make money for shareholders. But change is afoot, he acknowledged. A wider universe of businesses is open to investors, and the acumen of the people in charge is improving, in part because Chinese managers educated overseas are returning home for a piece of the action and bringing their expertise with them. "Things are certainly getting better," Muromcew said.
That may not be so in other parts of the world, and it worries him. Muromcew contends that Chinese stocks "have just been through a classic bear market bounce" and are due to head lower in response to economic conditions abroad, not at home. As China's customers go, he reasons, so goes China. "I think we're going to see continued weak numbers from the US consumer, and exports are still a key part of economic growth" in China, he said. "The data continue to be quite concerning."
Edmund Harriss, manager of the Guinness Atkinson Asia Focus Fund, has a rosier outlook than many of his peers. He shares some of their concerns but does not consider them deal breakers. "Has inflation moved into a phase where the government will have to take draconian steps to take control? My answer is no," he said. "Specific food prices have gone up for particular reasons for China, and those are subsiding."
Harriss also disagrees with those who say that the Chinese economy could slow markedly after the Olympics in August. "It's a big, high profile event, but even if you make a high-end estimate of how much they're spending on it, compared to the total size of the economy," he said, "it's not the only game in town by any stretch." Focusing on the country's many positives, Harriss noted that domestic investors have continued to put money into their market, especially in sectors like power generation, coal and steel, and he believes foreigners should join in. "For people looking at investing in China, the market has come down quite a bit, hit a low and recovered," he said. "Prices have stabilized as the picture has become clearer. The domestic economy seems to be growing on all fronts."
His favorite energy stocks include China Coal Energy, the largest producer in China; Yanzhou Coal Mining, which he called "a direct play on the sharply rising coal price"; Cnooc, the oil exploration company, and PetroChina, a more diversified oil business. His top choice among power generators is Dongfang Electric, and in transportation he prefers Pacific Basin Shipping and China Shipping Development. Moving away from the heavyish end of the industrial spectrum, Harriss likes the phone company China Mobile and the real estate developers Soho China and Guangzhou R&F Properties.
The sheer heft of the Chinese economy and what is seen nearly universally as a bright longterm future persuade many investors to put money into the stock market, even when they have qualms about the near term. Mengel has a shorter list than many. He holds China Mobile, Cnooc, and not much else. Muromcew finds more to like. Given his gloomy outlook on global economic growth, he is concentrating on likely beneficiaries of increasing domestic consumption and shunning export-oriented businesses.
"In the past the obvious sectors to focus on were exporters, but the renminbi has strengthened against the dollar and export markets are weakening," he said. "Also, China is no longer a cheap labor market." The renminbi is the Chinese currency, also known as the yuan. When it strengthens, it means a decline in revenue for exporters unless they raise their prices in foreign currencies, which limits their competitiveness. His favorite stocks include Ports Design, a manufacturer of high-end apparel for women and "one of the few Chinese brands that have gone global," Muromcew said. Other selections are Ctrip, an Internet-based travel agency, and the retail chains New World Department Stores and Intime.
Simon Hallett, who runs international portfolios for Harding, Loevner Management, also prefers shares of domestically oriented companies, but his choices are spread across a wider number of industries. Among his holdings are China Mobile; the coal producer China Chenhua; China Merchants, a Hong Kong-listed business that operates shipping container terminals; Jiangseu Expressway, which builds roads; China Mengiu Dairy and the brewer China Resources. He agrees with Harriss that the Olympics will not mark a turning point for China. At the same time, Hallett does not claim to know the next big catalyst for a move in Chinese stocks - in either direction. "From an economic point of view, the Olympics is clearly, no, I don't think there is anything clear about it," he said. "You can't use 'clearly' when talking about China."