Two Great Chinese Investments

Includes: CAF, CHN
by: Travis Johnson

In what might be a dumb move, I've picked up shares in a couple of China closed-end funds in the last few days.

I've tried to hedge my bets a little bit, however and I have acquired shares of both the China Fund (NYSE:CHN) and the Morgan Stanly China A Shares Fund (NYSE:CAF). These are extremely different investments, which I'll explain briefly. Basically, the China Fund is a mutual fund that buys stable, perhaps less-well-known companies that generally trade on non-mainland exchanges. I'd consider this to be the more stable fund, and a good long term investment. The China A Shares fund represents an investment in the actual bubble - the Shanghain and Shenzen traded A shares market that is dominated by Chinese retail investors. Both trade at stiff discounts to its net asset value - something on the order of 20% discounts in both cases, though that fluctuates a lot on any given day.

The China Fund is a more typical China mutual fund, with a long history, that happens to trade as a CEF. It has a couple of advisors who focus on buying non-state-controlled entities (this approach is common to many China stock advisors, including the newsletter editor Robert Hsu, who think that the state owned enterprises are too bureaucratic and corrupt). I like this one because I appreciate the focus on smaller and unknown stocks that it would be difficult for me to buy personally. It doesn't invest much on the A share market in Shanghai, but primarily buys Taiwanese, Hong Kong and other regionally traded shares that represent Chinese companies, or companies that primarily do business with China.

As of the end of April, its top holdings were:

Shanghai International Airport
Chaoda Modern Agriculture
China Merchants Bank
Daqin Railway
Shanghai Zhenhua Port Machinery
Golden Meditech
Financial Street
Xinjiang Tebian Electric
China Yangtze Power
Baoding Tianwei Baobian Electric
Powertech Technology
Cathay Financial
Merry Electronics
Formosa Petrochemical
China Oilfield Services

So I consider CHN to be a long term hold, which could obviously change. The expense ratio is a relatively reasonable 1.26%. CHN is now near a 20% discount to net asset value, which is nearly as high as the discount has ever been - in contrast, the premium has occasionally gone as high as 60%, though I don't expect we'll see those numbers again. I don't think this fund deserves to trade at the same high discount as CAF, below, because of its relative lack of exposure to Chinese retail investors.

The China A Shares Fund from Morgan Stanley is more of a short-term bet for me. I think that it's entirely possible that the Shanghai markets will continue to climb for the next 12 months, on balance, even following the remarkable returns it's already had over the past year. There are definitely a lot more negatives with this fund, including massively higher expected volatility, but I think it's worth a gamble. Shares have been trading at something like a 20% discount after being at almost as much of a premium as recently as December, and the Chinese A share markets have continued to set new records despite all the talk of bubbles, and state imposed control. This is essentially a small bet that at some point in the next few months - before the Olympics next year, certainly - that U.S. enthusiasm for the China A shares will return, and that the markets will not have a crash. But, I could easily be wrong.

CAF's top holdings, as of the end of March, were:

Huaxia Bank Co. Ltd
China Merchants Bank Co. Ltd
Shanghai Pudong Development BA
Daqin Railway Co. Ltd
Wuhan Iron & Steel Co. Ltd
Air China Ltd
Shenzhen Chiwan Wharf Holdings
Zhengzhou Yutong Bus Co.
China Coal Energy Co.
Maanshan Iron & Steel

As you can see, there is fairly limited overlap - Dagin Railway and China Merchants Bank are in both funds, though I expect the CMB holdings in CHN are Hong Kong shares, and not Shanghai shares (many companies list in both exchanges, at often different valuations). I've actually looked at China Merchants Bank as an independent investment idea before (in Hong Kong), because of its strong credit card business developing on the mainland, so I'm happy to have those shares doubled up in these positions.

The expense ratio is a relatively high 2%, thanks to the uniqueness of its portfolio in U.S. markets, which is part of the reason I won't plan to hold this one for a very long time - perhaps as much as a year or so, depending, of course, on how the market changes. I will likely keep a stop loss order on this one, which I almost never do for any investment.

So, a couple Chinese investments. One long term because I like the investment strategy, and one short term because I think the panic about A shares might be overdone. The short term one is also on a much shorter leash. I purchased the CHN shares at $35.08, and the CAF shares at $36.11.

Disclosure: Author owns shares of CHN and CAF.