The Case for Buying China Now

The Shanghai index (SSE Composite Index) - the best indicator of investing in China - is down 54 percent from its October 2007 high of 6124.04. But, for the preceding 14 years, China has been a great long-term investment. Although you can't invest in the index directly, an investment in Chinese stocks of $10,000 in 1991 (when the SSE index started) would be worth over $600,000 at market highs, before taxes and currency adjustments. Because of the correction, now is a great buying opportunity!

For much of recorded history, China has been an economic giant. According to The Economist:

"China was not only the largest economy for much of recorded history, but until the 15th century, it also had the highest income per capita — and was the world’s technological leader"

In the twentieth century China fell backwards - its GDP accounted for less than 9 percent of the world's output. Primarily because it missed the industrial revolution, experienced in the West . In 2000, Chinese GDP was still only one-tenth of that in the United States.

Some people still think of Communist China in "Cold War" terms. They are a rising super power with a sometimes secretive military build-up. They also, lack some political freedoms western countries take for granted. But, China's downside is far out-weighed by its future. As legendary investor Jim Rogers says "The Chinese people are the greatest capitalist in the world". Rogers should know, he has moved his wife and daughter to Asia because he is so excited about its future growth (I wonder if my wife would go for that). 

China has been under a microscope, receiving a lot of negative publicity from the upcoming Olympics. There has been a lot of talk about what can go wrong. Famed short seller Jim Chanos was on CNBC a couple of months ago. He mentioned that 25 percent of the factories are closing and will hurt the Chinese infrastructure boom. Infrastructure has doubled every 2 1/2 years. Some people feel China has gotten too big too quick. That is true in some cases. There is over development from the Olympics. Also in China, like in the rest of the world, there are a host of problems-namely high inflation, slowing demand and economic uncertainty.

Critics point to an over dependence on exports and slowing consumer demand from the U.S. Which leads to decelerating earnings along with higher shipping cost. Inflation is high, consumer prices increased 7.1% over the last year. Inflation is likely to diminish profit margins, but, that is happening all over the world. China has the financial strength to handle these speed bumps. Some analysts point to the controlled price of fuel as a sign of higher inflation to come. The Chinese government pays a heavy price for energy subsidies, but they have the cash. They do recognized this and are adjusting the price upward. China will deal with fuel prices like they deal with everything else-in a controlled fashion.

China's growth depends on commodities. They are critical for everyone. As the Remenbi starts to get closer to its free floating value, commodities will become cheaper, on a relative basis. No country in the world has been better at locking up supply. In fact, they have made a deal with Venezuela to have "the right of first refusal" on their oil-squeezing the U.S. out in a time of crisis.

Others say the China story is too dependent on exports-which are 40% of the economy. If the rest of the world goes into recession, they will get hurt. But, the Chinese people save more than 35 percent of their income, as the U.S. demand slows, domestic demand will speed up and over time, they will start enjoying some of their prosperity. Their economy expanded 10.1 percent over the last 12 months. Even if it slows, it will be among the fastest growing economies in the world. Any slow down has already been priced in.

The prosperity the United States enjoyed over the 20th century is the greatest in the history of capitalism. Gross Domestic Product [GDP] in the U.S. increased seven times on a per capita basis. Human nature equates the future with the past, but history rarely works that way. U.S. investors still want to invest in their own country. Even Sovereign Wealth Funds are pouring money into our markets, expecting high returns-as in the past. But, the U.S. fundamentals are not as good as they once were. The U.S. is in the middle of a financial crisis because of over-consumption, over-dependence on debt, and a housing bubble. And that doesn't take into account the coming entitlement crisis. 

China saves over 35 percent of their income, compared to the U.S., which saves 2 percent (some past quarters have been negative). Their country has 1.3 billion people-four times the US population. Its middle class is as big as the entire U.S.population, and is expected to double in the next few years. The U.S. current account deficit is 6.4 percent of GDP, while China has a surplus of 7.2 percent. The U.S. has a national debt of $9.496 trillion where China has a $1.3 trillion currency reserves-they have the world's best balance sheet. While America borrows $2 billion a day (more as oil increases), China has a surplus of $1 billion a day. The U.S. has deteriorated its industrial base, China's manufacturing sector is among the strongest in the world. The U.S. has neglected its infrastructure (Roger Lowenstien wrote a book about it) and China's is brand new. I could go on and on, but you get the idea. China's foundation is stronger. In the long run, the U.S. will be fine, but today China is a better opportunity.

On a recent trip to Israel, Warren Buffett said over long-term Israel has the same risk premium as the U.S. I believe the same could be said about China. Political Risk Services, a company who ranks countries investment risk-gave China a score of 79.3, ranking them the 35th best country to do business with and gave the U.S. 73.8, ranking them 57th in 2007.

China's long-term fundamentals are vastly superior to the U.S., and will cause de-linking at some point. During the 1990s, Japan-the world's second biggest economy-had a dismal economic performance, we did pretty good, while Japan was the U.S.'s biggest trading partner. Japan had speculation in real estate and the stock market that they had to work through, much like the U.S. today. China will still export but maybe not as much to this country. Domestic demand can only go up. From the World Bank:

In principle, it is easier for poorer countries to grow fast than for rich countries. With large gaps in productivity compared to “best practice”, poorer countries can catch up, or “converge”, simply by adopting techniques or practices from rich countries.

...

We are too early into the current global downturn to be sure about China. However, developments so far suggest that

(1) China has been affected significantly by the global downturn;

(2) China’s overall growth is holding up well.

...

On our projection, GDP growth would moderate to a pace broadly similar to potential output growth 9-10 percent, the rate of growth that the economy can grow at without running into overheating problems.

China is in its infancy. It is moving away from Communism toward entrepreneurship, deregulation and financial leadership. The market is poised to become more efficient and will support healthy long-term growth. Chinese companies have only began to fulfill their potential.

China has been the fastest growing country in the world for three decades and is expected to have the worlds biggest economy within 25 years. The economic expansion has been amazing, growing at nine percent per year since 1980.

Deregulation will add growth to China's future. China has a two share system. "A" shares for the Chinese people and "B" shares for foreigners. Experts expect that in the future, China will have a one share system, creating more investor interest around the world. Also, a free floating Remenbi, will attract more investment capital.

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China went from a bear market bottom in January of 2005 to a speculative top in October 2007. Because investors are re-valuing risk, stock markets around the world are correcting. The Shanghai index hit 1013.637 at the 2005 bottom. We are not going to see that level again. The Chinese stock markets are not a efficient as in the U.S., so they will be more volatile. Now is a period of uncertainty, that gives investors a chance to get a great growth opportunity at a value. What more could an investor want? Because the market is down 54% from its high last year, it represents a good value. It is time to invest. If your going to buy stock anywhere in the world it should be China.

It is hard enough to handicap stocks in the U.S., let alone Chinese stocks. The best way to invest is to put your money into an Exchange Traded Fund [ETF]. Investing in China is harder than in the U.S. Accounting regulations are not as structured and disclosures are uneven. Numerous academic studies have shown that index funds are more profitable than individual stock picks and will outperform most managed funds. For investors who do want to invest in individual stocks, I recommend Jim Roger's great book  "A Bull In China" where he summarize the major industries and select companies.

There are a handful of mutual funds and ETFs that invest in China. I think the best is FXI (summarized on Google finance):

iShares FTSE/Xinhua China 25 Index Fund (the Fund) seeks investment results that correspond generally to the price and yield performance of the FTSE/Xinhua China 25 Index (the Index). The Index is designed to represent the performance of the largest companies in the China equity market that are available to international investors. The Index consists of Class H and Red Chip shares of 25 of the largest and most liquid Chinese companies. 

Over the last year FXI is down 4.5 percent while the S&P 500 is down 20 percent. Over the last five years, the Shanghai index is up 77 percent but the FXI is up a robust 147 percent. The FXI also holds up well in declines. Since the October highs, the Shanghai index is down 54% while the FXI is only down 36%. You even get a little dividend. It has a p/e of 17. (FXI holdings)

My Investment

I am going to put 25 percent of my portfolio into FXI. I bought yesterday at $130 a share and plan on holding it for a long-term move, more than five years. If it goes down 25 percent , I will double my position.

One thing I am sure of-If you put money into FXI and the S&P 500, your wealth will be much greater in China (FXI) than in the U.S. (S&P 500) in ten years.

Disclosure: Long FXI

Comments

[Consider_this:]

People hear about china's stock market crashes and create a mental block about China's stocks. Looking at the chart and forward, much of the crash already happened. This is actually a good price point to enter into China.

The stampede of the 2007 is actually the worst time, yet ironically, everyone is screaming to buy china then.

Now it's a very good deal, yet everyone is ignoring China.

Go figure!

I think infrastructure play in China is the way to go. There's a lot of build out to go.

2008 Jul 21 11:58 AM

[John Pseudonym:]

Looking at the FXI chart, I would not buy at this time.

China will be a player in the world economy for the next century but so was the US in 1929.

There are times to invest and times to wait. Now is the time to wait.

The US and the UK will drag down the world economies and with it will come China. Afterwards, China will lead the way out and that's when I will move in.

2008 Jul 21 12:01 PM

[fxtrader07:]

'China's long-term fundamentals are vastly superior to the U.S., ...'

hm maybe - or maybe not. things might be a bit more complicated here than they look like on the surface. Apart from the fact that China is a heavily regulated economy with virtually no legal guarantees where your investment in any individual company can be wiped out by a stroke of the govt's pen, it is a socially very complex society. very divergent - between han mainland and the prospering coastal areas. maintaining a balance between the two is crucial to china and comes at a tremendous cost - something a GDP-comparison or any economic aggregate is unlikely to reflect.

Yes it may be a good time to buy - but the notion that a 54% drop represents 'value' is as as mistaken as can be. It#s a very common misperception by inexperienced traders/investors - and without wanting to insult, barely 5 years of investing experience makes you not more than a rookie. there are plenty of prtly hidden threats to that nice chinese growth story. and if i read that you allocate 25% of your portfolio to fxi - with another 25% when it drops further - i cannot but advise caution. as much as i like a concentrated portfolio, as much is this based on the premise that yopu must have a very very clear and thorough understanding of your investments. as for china - i think you barely have one. so investing 10% and another 10% after a drop might be more than sufficient. don't underestimate the huge risks involved! which brings me to my third observation: you are lengthy on opportunities and profts potential in your article - very short on risk. my suggestion is, try to find out as much about risks and what could go wrong as possible and write another article on that. it might not alter your position - but it will certainly strengthen your investment thesis - whatever that will look like afterwards

2008 Jul 21 12:27 PM

[Edward Janeck:]

This guy sounds smart!

2008 Jul 21 12:52 PM

[phdinsuntan...:]

guess what country holds more fannie maes and freddy macs bonds ?
yes, it starts with ch...

2008 Jul 21 01:17 PM

[Consider_this:]

The question here is not whether it will crash further. The author was trying to point out that we're pretty close to a bottom. I agree with him that the bottom is close.

Believing we'll go back to 2005 prices is dreaming, with a country growing at 10-12% GDP.

Also, waiting for a clearer sign also means that by then, the market will have gone up and it'll seem too high then. It'll always keep looking too risky and too high, since this is an emerging market. You can make the same or even more pessimistic argument (about the country not being ready, social/political risks, etc) all the way back from when Shanghai index started.

Look at an emerging market as it is, with all it's risk and reward together. There is risk, but if you believe in the China growth story, then we're very close to a good entry point if you have a 10-15 year outlook.

2008 Jul 21 01:29 PM

[John Pseudonym:]

"Also, waiting for a clearer sign also means that by then, the market will have gone up and it'll seem too high then."

Never try to buy at the bottom and sell at the top.

Buy on the uptrend and sell when the price starts to go vertical.

You will miss the bottom and the top, but will make money with far less risk.

2008 Jul 21 02:20 PM

[puttster:]

The only "reason" given to buy china is now is: "Because the market is down 54% from its high last year."

2008 Jul 21 02:47 PM

[User 142738:]

The fundamentals for FXI, or any Chinese stock and/or ETF, do all the explaining. Oil is a big contributor to losses here. A large chunk of the market capitalization is in large oil companies, but unlike all the other oil producers and refiners who make money in the “crack spread,” China’s oil companies’ profits are controlled by the whim of their government.

There are several articles quoting Chinese oil company spokespeople about how government price controls are cutting into their profit margins. Profit margins, according to the quotes, range between -40% and -50%. Common sense (and a healthy dose of economic theory) dictates that if a company is losing 50% due to government price controls, it must be due to the government holding prices down 50%.

So, according to that, gasoline must retail for about ¥3.6 a liter ($1.99 a gallon), right? Wrong. It retails for about ¥6.6 ($3.66 a gallon). Even with a half-off coupon they pay almost as much as Americans do.

I see any of three events happening by June 2009:

1.) In an effort to keep the oil companies afloat, China will keep raising and raising fuel prices. Costs for industrial production will spike, resulting in a massive migration of factories to a cheaper market (probably Mexico). Economic growth grinds to a halt. Unemployment and inflation shoot up. People get angry.

2.) In an effort to keep the people happy, China will keep subsidizing fuel prices. Import tariffs go up. Growth remains high, though it will solely be due to money supply expansion. Investors move their money en masse to other countries looking for the “next big thing.” Hong Kong stocks plummet and Shanghai stocks soon follow. China goes from a net creditor to a net debtor. People’s savings disappear. It’s Japan Part II.

3.) In a balanced point of view to keep people happy and the oil companies in business, China outsources all or nearly all of their oil exploration projects to BP, Shell, and other dirty, dirty foreigners. Import tariffs remain high but are positioned somewhere between the tariffs in the eurozone and the United States. Chinese stocks with little international exposure drop, but a few make it to the top. Growth slows, but remains modest.

Jim Rogers called the bottom for Shanghai in late May, then called it again in late June, and will more than likely call the bottom yet again in late July. I’m almost reminded of the childhood tale of the boy who cried wolf.

Eventually, people won’t care if the wolf exists or not.

2008 Jul 21 07:33 PM

[bigtime99:]

1) Average Chinese hourly labour rates are a fraction of Mexico's and will be for many years.
2) Japan is a post-industrial society and demographic nightmare with a falling population. China is a rural pre-industrial society that is a demographic dream with a growing population. Big difference.
3) Chinese oil companies? With their massive buildup of reserves they are buying Africa, next Canadian Oil Sands and then Latin American commodities companies. They are currently locking up supply; which is what the US thought they were doing 60 years ago with Saudi Arabia before a little thing called OPEC came along.
4) The future is in Asia, the writing is on the wall...if you don't believe it, go and see for yourself...

2008 Jul 21 11:38 PM

[Think-About-It:]

I think a better way to invest in China is to:

A) buy MCHFX Matthews China Fund which is very well managed and gives you much broader exposure than FXI with plenty of upside.

B) buy RJI (commodities Index Fund)

These can be your core "china investment" which you can augment with individual stocks that are either in China or will benefit from china's assent.

There are many risks to investing in China that the author glances over or simply ommits, however, I agree with him that long-term (10+ years) offers a great risk/reward for investors. It takes time for people to wake up to "game changers" [similar to what Michael Porter refers to as "disruptive technologies" in his Competitive Strategy books]. China's assent is a global game changer in many ways and any serious long-term investor must consider making investments that benefit from this.

Discloser: Own MCHFX, RJI, FEED, MPEL (watching BIDU, CHL, CTRP, LFC)

2008 Jul 22 12:32 AM

[Jase:]

I feel that Canadian Solar, Petro China (PTR), and FXI are among the best Chinese investments. My 24-month price targets for these are $110, $215, and $190 respectively. CSIQ has earnings growth of over 500% y.o.y., while PTR and FXI have excellent payouts.

2008 Jul 22 02:38 AM

[johnthebear:]

China can't make it selling to itself, even with it's huge population.

The global economy is on the verge of recession and some countryies will face depression before the tide turns, 4 to 10 years from now.

Get real and keep your powder dry. There will be a time to buy FXI, but certainly not now IMO. When that time comes, I will be a buyer of FXI.

FXP is a better bet. I look for FXI to go to 60 and FXP to go to 200 by November, 2008.

2008 Jul 22 10:07 AM