Why China looks like a buy

“A DIAMOND with a flaw is worth more than a pebble without imperfections,” goes the ancient Chinese proverb. That same thinking might apply to China’s stockmarket.

Why China looks like a buy

For a country that is expected to be an engine of global growth for decades to come, China has a long list of immediate concerns. The economy is slowing. Inflation is climbing. The real-estate market may be in a bubble. And charges of accounting shenanigans have soured some investors on Chinese stocks.

Those are some of the reasons why the MSCI China index has risen just 3 per cent since the beginning of 2010, compared with 20 per cent for the S&P 500 stock index.

And yet, despite its many problems, now might be a good time to invest in China. “At the moment, people are saying it’s over,” says Hugh Simon, manager of the Dreyfus Greater China fund. “But China still has growth potential.”

Why take the plunge now? Even a struggling China is expected to see its economy expand by 9.6 per cent in 2011, according to the International Monetary Fund. While that is down from 10.3 per cent in 2010, it could account for more than 30 per cent of the world’s total. On average, the IMF expects the global economy to expand by 4.3 per cent this year.

And the Chinese government is taking steps to stimulate growth further, from cutting taxes on the poor and middle class to funding public housing. That, in turn, should prop up construction spending and boost consumer spending.

Meanwhile, data suggest that China’s consumer-price index, which rose to a post-financial-crisis high of 6.4 per cent in June, may be cresting. China’s money supply, known as M2, dropped to 15.1 per cent in May, the lowest level since May 2005 — an indication that less cash is sloshing around in the system and that inflationary pressures may be ebbing.

If inflation tapers off, China’s stocks could get a boost. While rising inflation makes real profits worth less, and usually causes stock valuations to drop, falling inflation makes profits worth more and often makes valuations rise. Most famously, in the US, inflation fell for most of the 1980s and 1990s, and the stockmarket soared. Similarly, when China’s inflation rate jumped from 3 per cent in November 2003 to 5.3 per cent in July and August 2004, the MSCI China index rose just 2.2 per cent. A year later, inflation had fallen to 1.3 per cent — and the market was up 24 per cent.

What’s more, while China’s inflation rate is clearly too high, its 9.6 per cent economic growth gives it more latitude to attack the problem via monetary policy. In the U.K., by contrast, inflation is running at a 4.5 per cent clip, despite economic growth of just 1.6 per cent. Even in the US, inflation is running at an uncomfortably high 3.6 per cent, despite an economic growth rate of just 1.9 per cent.

Likewise, China, like Europe and the US, has a debt problem. On May 31 China agreed to provide as much as $US436 billion ($410bn) to cover bad loans made to local governments, an amount equal to about half of the US’s Troubled Asset Relief Program of 2008. But China also has a trump card that others don’t: $US3.2 trillion in cash reserves, by far the biggest hoard in the world.

“There are bigger problems in the US and Europe,” says David Semple, director of international equity at money manager Van Eck Global. “I would be worried about those things, not what’s going on in China.”

Perhaps most important, the recent market slump has China’s stocks looking cheap. The MSCI China index has a 12-month forward price/earnings ratio of 10.4, the lowest since 2009. The China index’s P/E is now at about a 17 per cent discount to that of the S&P 500. It hasn’t been steeper since January 2009 — over the course of that year the index returned 58.9 per cent, more than double the S&P’s 26.5 per cent.

That isn’t to minimise the risks in the China market. The biggest: Investors including hedge-fund manager John Paulson have been buffeted by a series of accounting scandals of Chinese companies listed in the US and Canada. Mr Paulson lost about $US110 million on one such position, which he began accumulating in 2007 and sold on June 17. Mr Paulson declined to comment.

So how to play China without getting burned? Here are some strategies:

• Buy dividend-paying stocks. One way to reduce the risks of accounting blow-ups wrecking your portfolio is to buy companies that pay dividends. A 2005 study of US companies by Judson Caskey and Michelle Hanlon of the University of Michigan found that while the fact that a company pays a dividend didn’t eliminate the chance of accounting fraud, it greatly reduces the odds.

If US history is a guide, Chinese dividend-paying stocks could be especially attractive now. Dividend payments were one of the ways that US investors knew they could trust the financials of US companies in the days before the US Securities and Exchange Commission and regulations requiring detailed financial disclosures, says Sam Katzman, chief investment officer at Constellation Wealth Advisers in New York. “If they pay a dividend, it’s an argument that they’re not playing with their accounting,” Mr Katzman says. “That’s where the US was and that’s where the Chinese are now.”

Chinese companies seem eager to win investors’ trust. Of the 147 companies in the MSCI China index, 89 per cent pay a dividend. Despite making up just 12 per cent of the MSCI AC Asia Pacific index market cap, China accounted for 28 per cent of the total dividends paid out, only slightly less than Japan.

Some mutual funds focus solely on dividend-paying companies in China. The Matthews China Dividend fund has returned 1.7 per cent this year, 4.7 percentage points more than the average China-region fund, according to investment-research firm Morningstar. Its biggest holdings are China Mobile, down 5.8 per cent, and Cheung Kong Infrastructure Holdings, up 24.6 per cent. The fund’s dividend yield of 2.21 per cent handily beats the S&P 500’s 1.84 per cent.

Investors need to be selective, however: the actively managed fund with the second highest dividend yield, EP China, has lost 9 per cent this year despite a yield of 1.65 per cent. Its largest positions include China Yuchai International, down 32 per cent, and Cnooc, down 1.3 per cent.

• Pick the right index funds. In most markets, buying an index fund can be the cheapest, most effective way to get market exposure. But because of the complexity of China’s market structure — companies can be listed in Shanghai, which isn’t open to most international investors, Hong Kong, Singapore and the US, among others –choosing an exchange-traded fund isn’t a simple, or necessarily efficient, way to play China.

Investors in Chinese companies have a bewildering array of shares to choose from: So-called A shares, which are available only to Chinese citizens and trade in Shanghai and Shenzhen; H shares, which trade in Hong Kong; “red chips” that are traded in Hong Kong but are controlled by the Chinese government; and shares of Chinese companies that trade on US exchanges as American depositary receipts, or ADRs.

Stocks of the same company on different exchanges can have wildly different returns, largely because the pools of investors are so different. Anhui Conch Cement shares listed in Hong Kong, for instance, have gained 63 per cent this year, while the company’s stock listed in Shanghai, whose market is open only to Chinese, is up just 45 per cent.

The upshot: Choosing the right index is critical. “There are hidden risks,” says Aaron Gurwitz, chief investment officer at Barclays Wealth. “The index may do well but the fund might not.”

The iShares FTSE China 25 Index ETF, for instance, owns the 25 largest Chinese companies listed on Hong Kong’s Hang Seng exchange. But more than 50 per cent of the portfolio is in the financial services-sector, which has the most exposure to China’s debt problems. The iShares MSCI China Index ETF has a 35 per cent stake in financials, but trades fewer than 7,000 shares a day, which can make it difficult for investors to get in and out of positions. The Market Vectors China ETF tracks A shares and has a 26 per cent position in financials but it must use so-called swap agreements to gain exposure because A shares aren’t available to international investors.

The SPDR S&P China ETF is Morningstar’s top pick. It includes 130 Chinese stocks listed in both Hong Kong and the US, trades more than 100,000 shares a day on average and has an expense ratio of just 0.59 per cent, the lowest among China-region ETFs. The fund is up 1 per cent this year.

Another option is to try to replicate the index without the financials. A June analysis performed by Adam Parker, chief US equity strategist at Morgan Stanley, found that a portfolio of nine Chinese American depositary receipts — China Mobile, Cnooc, PetroChina, China Unicom (Hong Kong), China Life Insurance, China Petroleum & Chemical, Yanzhou Coal Mining, Aluminum Corp of China and China Telecom have reliably tracked the MSCI China index since 2004, with a relatively steady correlation of 0.8 (a correlation of 1.0 means assets trade in lockstep). The portfolio has just 3.7 per cent allocated to financials, compared with 35.8 per cent for the MSCI China index.

• Invest in US companies that do business in China. “Chinese accounting takes scepticism to a whole other level,” says Stephen Tuckwood, senior financial analyst at Sanders Financial Management. “The safest way to gain access to economic growth in China is with US-based companies with Chinese operations.”

Investors who believe in the “China story” but still fear Chinese stocks could consider building a portfolio that mimics the MSCI China index but owns no Chinese stocks, says Mr Parker. Morgan Stanley’s recent study found that a portfolio of 17 equal-weighted stocks, ranging from Union Pacific and Colgate-Palmolive to Dow Chemical, had a correlation of 0.76 to the MSCI China index, when combined with a position in the S&P 500 and the S&P Metals and Mining Index. The portfolio mix: 18.6 per cent in the basket of stocks, 53.3 per cent in the S&P 500 and 28.1 per cent in the metals index.

Some companies that get a large percentage of revenues from China include fast-food companies like and Yum! Brands (36.5 per cent of revenue from China), McDonald’s (21 per cent across the Asia Pacific region), and Apple (12.7 per cent across Asia).

• Pay attention to where a company is listed. With A shares off limits, international investors should pay attention where a company’s stock trades. For instance, Hong Kong has been the go-to market for Chinese companies looking to list beyond their home borders: In 2011, 62 per cent of Chinese IPOs were listed in China, 34 per cent in Hong Kong and just 4 per cent in the US.

Why do companies come to the US? For the most part, it is because they believe their shares will be valued more by US investors than Asian ones. For instance, internet companies like Baidu tend to list in the US because investors here pay a higher premium for these stocks. (The listings work both ways — luggage maker Samsonite International, a Luxembourg-based company, listed in Hong Kong in part because Asian investors put a higher premium on luxury goods.)

While Baidu has gained 1643 per cent since the end of its first day of trading in 2005, Chinese companies listed in the US tend to underperform those listed in Hong Kong. The median five-year gain for a Chinese company currently listed on the New York Stock Exchange or Nasdaq with a five-year track record has been 36.9 per cent, compared with 60 per cent for Chinese companies listed in Hong Kong. Says Van Eck’s Mr Semple: “The action is in Asia.”

The Australian

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