Something Is Happening in China: How Investors Can Profit

China has already enacted a stimulus plan of decent size to combat their ailing economy. It is also widely believed that they are working to put together another stimulus that will surpass some of the largest expectations in terms of its reach and size. Beyond the sheer magnitude of the stimulus, it is designed with what appears to be broad economic stimulation rather than frivolous government spending. In addition, China has no capital gains taxes. I am not entirely sure if they have dividend taxes, but I am somewhat confident if they do have taxes on dividends, the tax rate is probably smaller than here in the United States.

Personally, I am growing tired of seeing countries previously thought to be “liberal” anti-business nations such as France, or Communist nations such as China, becoming what one might call more responsible capitalist moderate nations than the United States. That shall be enough ranting for this article.

So, how many of you have heard of the Purchasing Managers’ Index (PMI)? According to Investopedia, the PMI is a composite index of five "sub-indicators", which are extracted through surveys to more than 400 purchasing managers from around the country, chosen for their geographic and industry diversification benefits. The five sub-indexes are given a weighting, as follows:

• Production level (25%)
• New orders (from customers) (30%)
• Supplier deliveries - (are they coming faster or slower?) (15%)
• Inventories (10%)
• Employment level (20%)

As it turns out, China reports a Purchasing Managers' Index as well. In fact it was just reported a couple of days ago. According to China Daily,

The Purchasing Managers' Index (PMI) of the manufacturing sector rose to 49 from 45.3 in January, 41.2 in December and a record low of 38.8 in November, the China Federation of Logistics and Purchasing (CFLP) said Wednesday. A reading of above 50 suggests expansion, while one below 50 indicates contraction. The PMI includes a package of indices that measure economic performance. The survey covers purchasing and supply managers of more than 700 local manufacturers.

Granted, China’s economic growth is still in a period of contracting from their blistering growth rates seen in recent times. But it is becoming evident that stabilization is underway.

At least some of this stabilization should be attributed to good economic policies coming from Beijing.

Since late last year, China has announced several aggressive measures to ease the domestic impact of the global downturn. These included a 4-trillion-yuan (584.8 billion US dollars) economic stimulus package, a plan to expand rural home appliance purchases and support plans for key industries.

China hasn’t just left it at that. They are working on an additional stimulus plan, which if the first one was any clue, will be widely praised for its likelihood of success.

Zhang Hanya, an economist with the National Development and Reform Commission, the country's top economic planner, said gross domestic product growth (GDP) would bottom out in the first quarter as these efforts began to pay off. Zhang forecast GDP would grow 10 percent for the full year.

So, what is the actionable idea? Figure 1, shown below, is a chart of the monthly percent change of China’s Purchasing Managers’ Index from June 2005 through the March 2009 data point (which shows up as a percent change for February 2009). But how can investors gain exposure to these positive actions that are becoming more evident as each month progresses?

click to enlarge images

It is my understanding that China has two goals in mind as they create their economic stimulus programs. First, they want to purely stimulate their economy via creating jobs. Their country is lacking substantial infrastructure so, of course, a lot of their stimulus dollars are aimed in that area of the economy. Next, they have figured out that a purely production/exports driven economy is not necessarily the best thing compared to a balance between production/exports and their own internal consumption. So, what sort of companies might benefit from this stimulus? In my opinion several sorts of companies that will do well are copper, iron, steel, coal, and other various materials.

So the next logical step, make a portfolio of relevant “recovery” stocks that might serve investors well as a proxy for a Chinese recovery. The companies I think are logical for this exercise are Southern Copper (PCU), Freeport McMoRan (FCX), Vale (RIO), ArcelorMittal (MT), and Nucor Steel (NUE). I simply took an equal allocation of 20% in each stock to make the portfolio.

Figure 2, shown below is a graph of the monthly percent change of the portfolio of recovery stocks overlaying the monthly percent change of the China Purchasing Managers’ Index.

As you can see the portfolio of recovery stocks seems to correlate nicely with the China Purchasing Managers’ Index. In fact there seems to be some sort of leading power to the PMI index compared to the portfolio. Notice how the PMI has moved up m/m compared to the portfolio of recovery stocks in the previous few months?

I believe some very positive things are going on in China. Since we can’t count on the U.S. recovery anytime soon, maybe it is time for investors to look elsewhere. Perhaps more moderate countries moving in the right direction, such as China. I believe this basket of stocks coupled with a short position on SPY (to mitigate some of the volatility) will outperform the market over the next several years.

See here and here.

Disclosure: Author holds long positions in PCU, RIO, NUE, SCHN, PAAS.

Comments

[NickH:]

The elephant in the middle of the room that you choose to ignore is that who will buy the stuff that China's overbuilt factories produce? Read Roubini's article today. We too much production capacity chasing too few consumers=deflation. This story is based on rumors that another package is on the way. If you want to believe every rumor, press release and goal that comes out of China and call that analysis, you can do it. But for reliability, I think reading tea leaves would do better.

Mar 05 11:55 AM

[anarchist:]

And who can trust the numbers coming out of China? Is China even capable of giving out a realistic PMI number it they wanted to?

Mar 05 12:09 PM

[367851:]

He believes the Chinese will start buying more of their own stuff.


On Mar 05 11:55 AM trader1234 wrote:

> The elephant in the middle of the room that you choose to ignore
> is that who will buy the stuff that China's overbuilt factories produce?
> Read Roubini's article today. We too much production capacity chasing
> too few consumers=deflation. This story is based on rumors that another
> package is on the way. If you want to believe every rumor, press
> release and goal that comes out of China and call that analysis,
> you can do it. But for reliability, I think reading tea leaves would
> do better.

Mar 05 12:19 PM

[hamsami:]

Wrong...China do not stimulate or spend they invest. In this way they become more capitalistic than the People Republic of America as we are becoming. If we continue to stimulate/spend we create an ISEP, it somebody else problem. If we invest then their is accountability and an expectation of a return. Right now we are hoping like hell something works with no expectation or a demand of a return.

Mar 05 12:29 PM

[hamsami:]

FYI: ISEP see Jared Diamond: Collapse:How Societies Choose To Fail Or Succeed

Mar 05 12:49 PM

[damjanovic:]

This story isn't based on rumors or announcements of stimulus packages. It's about seeing if demand for base metals is significantly impacted by China. As you can see in the graph, especially in the last year, the Chinese PMI tends to lead the stock prices of base metals produces by a couple of months or so. This makes sense from a fundamental standpoint. I think this is a decent analysis.

As for the purported quality of Chinese statistics, at this point they're probably no worse than the crap we publish here in the U.S. (substitution-adjusted inflation numbers? imputation-bloated GDP figures? unemployment calculations that get revised (always with a positive bias) every 10-15 years? any of that ring a bell?)

Mar 05 01:20 PM

[Mark Anthony:]

I agree with your basic analysis of China's economic stimulus programs. But, instead of concentrate on individual base metals and raw materials, mwho not look at something which is common to all raw materials: The common thing is SHIPPING. All raw materials need to be transported to China by ocean ships.

I believe the dry bulk shipping sector is the best thing to buy to play the Chinese economic stimulus. Read here:
seekingalpha.com/artic...

All the stocks you listed look like good long term buys. But better profit potential is in shipping as this sector was way over-sold recently, judging from the strong rebound of the BDI shipping index.

Mar 05 01:28 PM

[damjanovic:]

You missed the point of the article. Base metals aren't used to produce toys and cellphones. They're used for infrastructure. The Chinese are going consume the capital goods they build - the stimulus package isn't really aimed at ramping up export production.

On Mar 05 11:55 AM trader1234 wrote:

> The elephant in the middle of the room that you choose to ignore
> is that who will buy the stuff that China's overbuilt factories produce?
> Read Roubini's article today. We too much production capacity chasing
> too few consumers=deflation. This story is based on rumors that another
> package is on the way. If you want to believe every rumor, press
> release and goal that comes out of China and call that analysis,
> you can do it. But for reliability, I think reading tea leaves would
> do better.

Mar 05 02:00 PM

[Amouna:]

Very true. America's Economic Model of Consume to Growth is DEAD. But politicians would rather keep printing money and re-inflating a walking zombie than face the harsh reality and start preparing for it..

When you think about it, it is all logical. Chinese people, if its true that their economy was often oriented towards exporting to the US, are not slaves. They are hard working people willing to advance their country. They will suffer a harsh recession to readapt but eventually a decoupling will happen over time, as they start building their own consumer base and investing in their infrastructure.

Who can trust numbers coming out of the FED? please give me a breeaaak..



On Mar 05 12:29 PM hamsami wrote:

> Wrong...China do not stimulate or spend they invest. In this way
> they become more capitalistic than the People Republic of America
> as we are becoming. If we continue to stimulate/spend we create an
> ISEP, it somebody else problem. If we invest then their is accountability
> and an expectation of a return. Right now we are hoping like hell
> something works with no expectation or a demand of a return.

Mar 05 03:28 PM

[Spook:]

I will the report a merit, although not sure how the PMI is being interpret.

In the 4Q of 2008, everyone here in Taiwan to China slam their brakes on forecasting and ordering, due to a sharp decline in sales in US and in Europe, as well as pilling inventories.

Since January, we noticed that the domestic retail in China has some activities, retailer and reseller will ask around for inventories, brand is no longer an issue, he who have stock and deliver get the orders.

Local information here also shows that China government subsidize a Taiwan LCD TV maker late last year, not only to help it survive, but to use the product to promote it to remote regions, one way of China stimulus.

All these index is not leading to export, but to local consumption.

I know there are few readers here that are already based in China, whats their thought on this?

Mar 05 05:11 PM

[Alan Young:]

Whether China taxes dividend payments is pretty much moot, since the government owns a high proportion of the stock and can essentially dictate what the dividend payment will be in the first place.

Your chart of month-to-month changes shows increasing volatility; it does NOT show what the overall trend is. Why did you choose a measurement which obscures the very point you are trying to make?

And, aside from RIO, your choice of "proxy" companies is highly suspect. China imports much more raw material from Australia, Russia, and Africa than from the American and European companies you have chosen.

I wish there were a clear line of insight into the Chinese economy. Perhaps your computations are useful as part of the picture, but they are far from sufficient or convincing.

Mar 05 05:17 PM

[surf:]

If the Chinese do, in fact, exectue an economic stimulus program, how are they going to pay for it? Buy (recycle) fewer US treasuries? Is this effectively a way of unloading some of their gazillion $ of US treasuries?

Mar 05 06:29 PM

[Daniel Moser:]

The Chinese can afford to pay for their second stimulus plan because they have been running tremendous current account surpluses. Yes, I think you make a valid point that they will indeed have less desire to buy U.S. treasuries as they fund their own economy. Moreover, as they build out their own internal consumption, they won't have as much desire to hold U.S. Treasuries in an effort to keep their currency low to maintain their export driven economy.

In addition, I do not believe that showing percent changes m/m obscures the very point I was trying to make. I am fairly confident that I am most interested in percent changes so that one might observe any correlation between my "suspect" basket of stocks and the PMI data. Especially considering that PMI data is somewhat unusual in that absolute levels have a different sort of interpretation than typical data series (i.e. >50 is economic expansion and <50 is contraction). So, i am pretty sure overlaying the raw number would have been pointless.

I am going to take a look at the freight companies to see if there might be some insights gained from those. However, I am don't know much at all about freight companies so I am definitely open to suggestions for freight companies that are less likely to have accounting scandals than others.

With respect to those who appear to get frustrated at anyone who would dare take a glance at Chinese data, I am well aware that the precision of the numbers are highly questionable. Although I must ask, if the Chinese numbers are not to be trusted, why do they show anything bad at all? Which is to say, why would the big bad communists ever show PMI data less than 50? Or declining GDP growth? Furthermore, a grain of salt is always needed when looking at any economic or accounting data.

This is just a tiny trickle of information for those interested in forward looking investment ideas. If you don't like them, don't use them. If you do like them, find them interesting, and wish to build upon them with your own constructive ideas, awesome and I wish you luck.

Mar 05 07:19 PM

[nova:]

Twenty-tree years ago, everybody thought that Japan was "unstoppable" overtaking the rest of world.

Now, many people think the same about China. Will an "unthinkable" happen to China when it will become suddenly stagnant and overwhelmed with too many problems? It is a good question.

Right now, using its cheap and forced labor, and technology bought and stolen from all around world, China has developed incredible industrial capabilities.

However, China has many weaknesses that could seriously jeopardize China future:
- China is a Communist state with its bureaucracy running the show. It is a very inefficient economic model and very slow to change.
- China is an "export-dependent" economy. It has very little control of its economy being too dependent on outside world.
- The rest of world has very little money to pay for Chinese export.
- China is very dependent on outside world for natural resources, commodities supplies from oil to industrial materials to agriculture, et.,. In its quest for natural resources, China inevitable will enter into a major confrontation with other major industrial powers.
- It will be very difficult for China to stimulate its economy. China population has very little money to spend. Their standards of living are very low.

The Bottom Line: Chinese future is not that clear.

Mar 05 09:57 PM

[ArtfulDodger:]

Good article. China looks to be the best long term play in the world at this point. At least it's pro-business.

Mar 06 09:08 AM

[auto44:]

Jim Rogers in his book adventure capitalist explained that the folks running China are very smart about economics and the folks running our government are very dumb on this subject. Who knew? he explained it more diplomatically than I did,there is nothing dumb about Mr. Rogers.

Mar 06 12:37 PM

[Spook:]

This is when the government steps in, subsidizing a large portion of the bill, the recent LCD TV sold to rural areas, largely subsidize by the government. Now almost everyone in rural areas have LCD TV.




> It will be very difficult for China to stimulate its economy. China
> population has very little money to spend. Their standards of living
> are very low.
>
> The Bottom Line: Chinese future is not that clear.

Mar 16 12:10 AM