11 Reasons Why It's Time to Invest in China and 5 Ways to Play It

By Louis Basenese

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:

1. 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.
2. 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.
3. 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.
4. 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.
5. 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.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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.
11. 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.

Disclosure: None

Comments

[blackbody:]

non-sense.

Jan 15 07:21 AM

[donzelion:]

When investing in China, bear in mind that the transparency will always be much less than even the numbers put out by Bear Stearns and AIG. Hence: a higher multiple is appropriate, and a higher dividend, and "earnings growth" or similar rubrics should be treated with extreme caution (unless you are managing a Chinese bank or factory yourself, in which case, you have enough information to make informed judgments).

Jan 15 08:14 AM

[ArtfulDodger:]

Excellent article.

Jan 15 08:52 AM

[boost:]

Yeah, there's been nothing but transparency with the US companies. Its no different here. In this day, you cant trust anyone, not even the SEC to tell you the truth.

Jan 15 08:55 AM

[rlirph:]

Most people forget that China lives on exports. When the economy of US and Europe declines China has farther to drop.

As to the Chinese shares selling at 8x earnings we have to deal with transparency and accuracy. In addition analysts here and in the US are alike - look at how much cheaper US stocks are now - but they have not marked down the more realistic earnings. When one factors in the 'real' earnings stocks in US and China are no longer cheap. I like to see specific examples to show how many company's earnings are increasing and not decreasing.

Because the Chinese have traditionally saved 40% of their income when the economy contracts the consumers are the first one to defer buying. Just look at their automobile sales in 2008. The sales figure has hit a wall long before the US did.

Locals so far are somewhat optimistic because they still have jobs. When more jobs are eliminated in Southern China (called Pearl Delta, the Shenzhen-Guangzhou-Zhu... triangle) which is happening now those optimism will fade fast.

Jan 15 09:01 AM

[johnthebears:]

rlirph: You are Bang ON!

China has done it's best to prop up it's sagging market. Remember when the said 3,000 was the absolute bottom... no way would it be broken... well now it is 1,920 and the 52 week low is only 1,844? Remember when it was over 6,000? May bottom out at 1,500, if we are lucky.

There is no way to stop the declines in China stocks... just as it is in the rest of the world.

Be short (puts) FXI and EEM or sit on your cash if you have to invest in China and BRIC.

As I see it, commercial real estate all over the world has far to go down the tube, and this has not been reflected by our banks nor the banks in China. There is nothing to suggest improvement in 2009 or 2010.

This thing will take a long time to resolve. After all, the world has lost over 31 trillion dollars in equities! That is money down the tube and governments have no one to borrow from except each other and who would trust them?

As a play on declining commercial real estate, look at Calls on SRS at a $200 to $350 strike price for April 2009, which I own.

Jan 15 12:02 PM

[Larry House:]

What has happened to "smart money" in 2008? Let's get real, people. China isn't going anywhere without the rest of the world.

Jan 15 12:19 PM

[Josh Stern:]

I agree with the thesis of the article and I've acted on it (my positions are in different stocks than the ones mentioned). However, my experience suggests that the greatest risk to investing in at least the smaller Chinese companies that one is attracted to because of their very low valuations is that the mgmt. and BOD (often controlled by the same principals) believe they are growth companies and will typically attempt to pursue overall growth rather than Ben Graham type shareholder value. In fairness, they are often just doing what they claimed they would do in their original IPO prospectus, but shareholders are inevitably disappointed when companies with trailing P/E under 4 and a lot of cash choose to use the cash to acquire another company with trailing P/E of 10 or worse, invest the cash in a new facility costing 20-50% of their then current market cap.

Jan 15 12:45 PM

[Jae Jun:]

Another HUGE factor to consider is the ethics of Chinese businesses. No way are they anywhere near the standards of the west.

We take it for granted here in the US and thankfully only a tiny number of companies still manipulate numbers, but in emerging countries this number will be much much higher.

Jan 15 01:30 PM

[Scotty Sparks:]

Interesting article but the writer didn't mention whether or not he owns shares in the companies he's recommending. How about it Louis? Do you or do you not? If you do then enlighten us readers as to which ones.

Thanks
SS

Jan 15 03:46 PM

[tilut:]

Good Article , we need more of them as most usual articles tend to be against investing in China , what appears to me to be ridiculous since it is the place for growth in the next decades.

Jan 15 04:48 PM

[Dr. Faheem ...:]

China is the world biggest exporter, current credit crunch will not effect China as severe than the rest of the world; as its products will remain the most cost effective to rest of the world.

Jan 15 05:05 PM

[Firat Ünlü:]

Good article, my money's also in China.
Any piece on riots & dissidends I've come across has been poor at best, neglecting political realities within China and historical backgrounds.
Recently there was an article on the China Daily website that announced that measures would be taken to make sure graduates would find a job, as to be expected with such a track-record of being simply competent in doing its job the CCP has managed the biggest short-term danger. Political front is clear, expect more bailouts and additional help for companies, furthermore there's huge pressure on companies not to lay off staff, not to mention that there's always space for an additional worker in China.
I remain highly sceptical about the British pound and American Dollar but given my limited resources I'd play the pound rather than the dollar for the simple reason that the big boy usually has an ace up his sleave.
Why take in the danger of unknown psychologial reactions for the world's reserve currency when you can get similar, if not worse, fundamentals with a much weaker government and currency?

I'll have a closer look at transportation & infrastructure (expect subways to come up in cities you haven't heard of soon) and possible contractors of the defense sector (huge build-up ongoing).
Whatever, the same daft ones that lost their clients 50% last year will miss out on a China rally for being as intelluctually lazy as to not read a few proper books on China and actually talk with ordinary Chinese people.

Jan 15 09:46 PM

[Firat Ünlü:]

Oh, and if anyone thinks that crumbling exports will lead to implosion in China should have a closer look at statistics for countries like Germany where the number of people contributing (social security payments etc) is already smaller than those of people receiving benefits.
Can anyone say imbalance?

Jan 15 09:52 PM

[hankt:]

Hmmm...China real unemployment in December was officially recognized as 6.7m newly unemployed and did not take into account 670,000 small firms that had closed. The official number from Beijing only included registered urban jobless statistics. An adviser to China's State Council stated that the number was about 8.3m. Shortly afterward around 4,800 toy manufacturers alone closed shop.

Let's take a look at some other interesting numbers.

Lenovo and other tech, both chips and finished components, are issuing profit warnings as exports dry up and domestic spending on the consumer and industrial levels pull back. Lenovo cut 2,500 jobs, warned that would likely not pay dividend.

Asia to anywhere shipping spot prices have fallen to 0.00 - regardless of what you see in the small BDIY increase (1/10 of August values btw). This is an historic, never before seen event. Lloyd's List has quoted executives that have stated that they are shipping at 0.00 plus the cost of fuel. Shippers themselves are warning of bankruptcy.

Shipbuilders are seeing existing orders cancelled and the 2009 expected orders evaporating.

* HK exports lower than Feb 03 at 6.85bn vs. 7.10bn in 03.
* KR export nearing 03 lows (289m per month in May) with Dec numbers @ 373m
* TW exports have nearly halved since August (25.25bn) at 13.6bn. The low in
2003 was 9.82bn or just 28% below December. November to December dropped
18.8% alone.

China's motor vehicle sales are below SARs 2003 levels and the industry, with the government's backing, is calling for consolidation in order to prevent manufacturers from going under.

As industrial output has been dropping, power plants have seen much lower utilization and are using less coal, oil and gas.

The housing and building developers are halting projects on dried up sources of funding. Hong Kong home sales by number of transactions are worse since 1996 (spanning both SARS and the Asian Crisis).

China steel is in the same boat as autos and regional shippers; with no use for steel outside of state sponsored infrastructure China steel mills are shutting down or running at diminished capacity. Consider:
"Jan. 14 (Bloomberg) -- Baosteel Group Corp. closed six
blast furnaces since October after demand fell, the Shanghai
Securities News reported.
The closures cut 2008 profit by 32 percent to 23 bn yuan
($3.4 billion) and lowered fourth-quarter output by 30%, the
report said, without giving production details. Two of the
smelters were turned off and four weren’t restarted after being
shut for regular maintenances, the paper said.
Wuhan Iron & Steel Group also has kept some furnaces shut,
the report said. Its total profit fell 18 percent to 7.6 bn"

If you are not going to pay attention to these indicators and must invest in China, limit your China exposure through the HK ISHARES A50 China Tracker 2823 HK or Wise CIS 300 China Tracker 2827 HK - at they are highly liquid and you can back out in a hurry.

It will be a scary time to hold em, but as the stimulus spending is unleashed in China things should be OK. Unfortunately, they may not go beyond domestic production needs in utilization of coal, oil, gas, steel, cement, etc. in order to help out their neighbors.

Hank
[e-mail]

Jan 16 02:58 AM

[turb0kat:]

Thanks for the ideas :) I have 30% of my portfolio in China but I hadn't discovered EJ yet.

Jan 16 11:35 AM

[CarbonDhari:]

Have anyone discovered India???

Jan 18 03:59 AM

[Firat Ünlü:]

India is the new Bolivia, so far they managed the easy part (service and IT sector where they had a historical advantage), now let's see how they deal with coming up with jobs for hundreds of millions of people. The number of people living on less than $2/day in India is the same as in sub-sahara Africa, in fact the number has actually risen in the past in India, disastrous 'achievement' considering the environment they'd been in. The tough part is getting proper well-paying jobs for all those which involves a ****load of good governance and careful planning/regulation.
Being poor itself means little but it's a common mistake amongst economists to wrongly project into the future. So far India's GDP is three times larger than that of Taiwan. Now is the time for Indian politicians to rise up and to their properly for once.

Jan 19 02:11 PM

[jeandit75:]

re: china stock cheap
before CSR dropped 30% in 5 days certainly not...now, may be not as well. Chinese cies have higher cost of capital from a higher cost of equity making a PE comp with US cies irrelevant. CSR also has governance problems. A bad stock is never too cheap to buy.

Feb 22 04:09 PM

[thotdoc:]

1/2 a year later...he was a fortune teller.

Jun 06 05:49 PM