Speculation continues to run high on the issue of whether China is experiencing a bubble that threatens investors. Chinese real estate looks hugely overpriced and manufacturing capacity (according to some) has run far in excess of potential demand.
On the political front, an argument has erupted between the Chinese government and Google (GOOG). Google claims that China hacked the email accounts of some of its customers, who coincidentally were human rights crusaders. Meanwhile, China wants Google to block websites that spread pornography, violence and political dissent.
We've spent a lot of time looking into China and, despite these issues, we remain firmly convinced that China should be a part of every investor's portfolio. What's more, we have revised our strategy with regards to China, and now believe that you should not attempt to profit from China's growth by investing in companies like Wal-Mart (WMT) or Johnson & Johnson (JNJ) that have exposure to China. Instead, we think you should invest in companies domiciled in China.
Granted, it is more difficult to buy shares in Chinese firms. You may need a full-service broker for certain issues not listed in the U.S. However, we have some suggestions to make it easier.
Here are a few, along with some info on how we reached these new conclusions...
The Easier Way to Invest in China
The easiest way for most Americans to make money in China is to purchase shares of two funds. The first is an ETF called the iShares FTSE/Xinhua 25 Index (FXI), which invests in China's 25 largest and most liquid shares, including many of the top dogs in its financial sector.
Next, our top diversified pick is The China Fund (CHN), which invests in both public and private Chinese companies. CHN may be a little riskier than FXI, but the risks seem well worth taking.
If you do have a full-service broker who can purchase overseas shares for you, we have a few Chinese stocks that strike us as particularly promising. They are the consumer products maker, BaWang, and two railways, DaQuin Rail, and Guangshen Railway (GSH), which are essentially infrastructure plays.
As for the issue of China's “bubble,” let's first look at the government's dispute with Google.
As with everything in China, things are not what they seem at first glance. From now on, the new rules of the global economy will be made in China rather than the U.S., and that will create a fundamental shift in power and philosophy. Ten years from now, there may be a whole new set of textbooks on economics and political science that praise the Eastern approach more than the West. The story doesn't have to have a bad ending for the U.S. But we had better start looking at things through the eyes of China if we want to come out ahead.
The issue with Google is the perfect example of Westerners misunderstanding China's point of view. The Chinese don't really care whether Google operates in China or not. Google's threat to withdraw from China is empty. If Google left, China would simply have one less headache to deal with. The loss would entirely be Google's and its investors. Indeed, as we explain below, Chinese strategy is to assure the economic riches the country produces accrue, to the greatest extent possible, to domestic rather than foreign companies.
(Incidentally, if Google does pull out of China, we would also add the Chinese search engine company Baidu (BIDU) to our list of top Chinese stocks.)
A similar misperception exists regarding China's excess capacity. As far as we can discern, all the excess capacity in China has either already been absorbed or soon will be. China's plan to develop alternative energy requires far more capacity than currently exists.
To take one example, the Chinese already buy more cars than Americans. By 2020, China intends to have 50% of those cars powered by electricity, which in rough terms would mean that at least 60% of new car sales would be electric – where copper use is twice that of a conventional car. We won't even go into the math on that one, but the implications are staggering. So there's really no bubble in China's industry.
As for the real estate bubble, that too is not what it seems. Soaring real estate prices in China appear to originate from Chinese cities, such as Shanghai, auctioning off enormous tracts of land. The winning bids for many of these plots have been astronomical, and far ahead of the runners-up.
Who has been placing these winning bids? None other than state-owned enterprises. In other words, the Government of China. These state-owned enterprises (SOE) get their funding from the government via Chinese banks.
In America, if our government were paying above-market prices for land, we would protest the waste of taxpayer money. But in China, it's part of a master plan to develop the country while retaining government control over the economy.
You see, Chinese cities work quite differently from their U.S. counterparts. For instance, a recent article in the Shanghai Daily commemorated the opening of a $2 billion semiconductor plant, which was a joint-venture between the city of Shanghai and the manufacturer. These types of joint-ventures between cities and companies are the norm in China.
And it's not just Chinese companies that take part in these joint ventures. Foreign companies (such as autos) also operate facilities in China as joint ventures with the cities they are located in.
You might ask where cities get the money to invest in such projects. If a city wants to borrow from a bank, it usually must put up land as collateral. The borrowing would be limited to the fair value of the land. These valuations would not be nearly enough to satisfy the cities’ multi-billion dollar ambitions. So, the government helps cities by encouraging SOE’s to bid sky-high prices, which in effect transfers money from banks to cities. If the loans go bad then the whole transaction simply amounts to a transfer of cash from the central government to the city. If the SOE is able to earn a return on the property it’s so much the better.
The system gives city officials a bigger hand in the local economy, which helps decentralize power for greater efficiency. It is a system that helps China retain control over its economy, because the government winds up with a finger in every major enterprise. Keep in mind that city officials will in some way report to the honchos in Beijing. The key words are decentralization and efficiency.
China's methods are radically different from what our governments do. Can you imagine New York City entering into a joint venture with a semiconductor or automotive plant? (Well, perhaps Flint, Michigan wishes it had bought a big chunk of General Motors a few decades ago, in order to have had more of a say regarding plant closures.)
Bottom line here: China does not have a real estate bubble; it has a joint venture scheme between business and government. It has a vigorous marriage between socialism and capitalism that we would be foolish to bet against.
In the context of growing energy scarcity, do we really want to bet against a country that has turned a start-up oil company into the world's largest in just 12 years? A country that is now #1 in every form of alternative energy - electric cars, solar, wind, nuclear, you name it? Let me give you one more stock recommendation that could prove very profitable in a few years...
In the Long Run, Choose Wumart Over Wal-Mart
Rather than invest in Wal-Mart (WMT), may we instead suggest you take a look at the Chinese company, Wumart? That's not a joke; it's a $16 billion Chinese supermarket chain which The China Fund has invested in.
A lot of money will be made in China over the next few years, but most of it will be made by Chinese companies rather than foreign-owned ones. China will remain somewhat dependent on exports for some time, but that dependence is already weakening. China's exports fell dramatically in 2009, yet its GDP still rose 8.7%.
The apparent real estate bubble, while not an illusion, has been created by the government itself and will be managed by the government. Sure it has ramifications, but they will be far less damaging than our subprime crisis. Debt levels are very low in China's residential real estate market. And there are no subprime borrowers. So the bubble can be deflated very slowly, should it ever be a problem.
All that said, China remains a fierce economic rival to the U.S. Our government will make a big mistake to underestimate them. Asians know how to think very long term and stick with their plan.
To take a minor example, I met a Tibetan cab driver this morning, and when I told him I hoped his country achieved peace within the next ten years, he said to me, “No, ten years is too soon. Maybe in the next 2-3 generations.” Not too many Westerners think that far in advance, and the loss will be ours.
Meanwhile, as individuals, we can at least make a lot of money hitching our wagon to the rising economic powerhouse.