Investing in China Is Still the Best Long Term Play

By Jason Simpkins

While a recent crop of economic data suggests that China is not fully insulated from the economic turmoil that has overtaken the United States and Europe, some of that data is suspect. The upshot: The world’s fastest-growing economy is still much better off than its Western counterparts and probably remains the best long-term option for globetrotting investors.

China’s benchmark Shanghai Composite Index has plummeted nearly 70% in the past year. A big reason for the decline was concern among investors that economic chaos in the United States and Europe would deplete China’s breadwinning export market. But, so far, those fears have proven to be largely unfounded.

China’s exports grew 22% in the first eight months of the year, despite sluggishness in the global economy and turmoil in the world’s financial markets.

Even more impressive: China’s retail sales grew at the fastest pace in at least nine years last month, soaring 23.2% to $128 billion. Retail sales climbed 22% in the first eight months of the year, a hefty jump from the 16.8% pace for all of 2007.

So even if exports do diminish, there is a mounting body of evidence that suggests China’s domestic demand will be enough to offset global weakness.

"Our outlook for consumption growth remains broadly positive," said Jing Ulrich, JPMorgan Chase & Co.’s chairwoman of China equities, in a research note.  "As China’s government attempts to move from export-dependent growth, we expect that additional resources will be pledged to support domestic consumption."

This is also true of China’s industrial sector, which many critics contend is showing signs of weakness. China’s industrial output expanded 12.8% in August after growing 14.7% in July, according to the National Bureau of Statistics. But there is a strong possibility that output will ramp back up over the next several months, as factories that were closed for the Olympics come back on line and Beijing sets out to rebuild areas of the country devastated by an earthquake earlier this year.

The government closed down a multitude of factories in and around Beijing to keep pollution from blemishing the Summer Olympic Games. Factories closed in Beijing and the surrounding areas account for 26% of China’s economy, according to Goldman Sachs Group Inc. 

"We expect industrial activity to pick up with the reopening of factories in Beijing and surrounding areas," said Ulrich.

Merrill Lynch & Co. Inc. estimates the factory shutdowns, combined with weaker demand for steel and cement, knocked 2.5 percentage points off headline growth.

"We expect a post-Olympic rebound in industrial production growth on both pent-up demand and the post-quake reconstruction," said Merrill economist Ting Lu. The tab for rebuilding large portions of the Sichuan region after May’s devastating earthquake is expected to run about $78 billion.

With such robust growth in so many key sectors, a 70% decline in stock prices is almost baffling, unless you consider the troubles that have beset U.S. and European financial companies, as well as the gradual extinction of Wall Street’s once-proud investment banks.

According to Jonathan Wu, head of distribution at Premium China Funds Management, cash-strapped U.S. and European banks have spent the past year liquidating their Chinese assets in a desperate bid to shore up their balance sheets.

"It’s just sheer panic. U.S. and European banks are suffering to keep themselves afloat [amid the sub-prime crisis]," Wu told IFA. "What we have seen is that they are selling holdings in Chinese companies because Chinese stocks have been most profitable [for investors]."

It remains unclear when China’s stock indices will bounce back, but Wu says investors won’t be waiting for a U.S. recovery to pump cash into Chinese equities - especially at their current deeply discounted levels. Price/Earnings (P/E) ratios for Chinese stocks have plunged from about 40 last year to 14 in September.

"[Investors] may lose another 10%, they may lose another 15%," Wu told IFA, "But on a long-term trend, because of the fact that we are just buying these value stocks that have such good fundamentals behind them, once there is that confidence restored in the market, stocks will fly."

China Still Head of Strong Emerging Market Class

There’s little doubt that China’s economy will expand at a slower rate going forward, but it’s becoming more evident that the country’s vulnerability to the turmoil plaguing the West has been greatly exaggerated. China is still expected to lead emerging markets in a period of strong growth throughout 2009, even as the United States and Europe continue to struggle.

"The negative impact coming from the global slowdown will continue to affect Asian economies, but the extent of the impact will be small and felt more next year," Haruhiko Kuroda, President of the Asian Development Bank, told the Financial Times. "But even then, the impact, or downward adjustment, will not be as great as some of us had feared [because] real demand is strong, including domestic demand [and] investment as well as the consumption are strong."

China’s economic growth will remain unchanged at 10% this year, the ADB said last week. Growth is then expected to slow 9.5% in 2009, which would still handily trump whatever growth developed economies manage to muster up.

A survey released Tuesday found that the overwhelming majority of executives operating within emerging markets are optimistic about their growth prospects over the next two years, Reuters reported.

About 87% of executives operating within emerging markets are optimistic about company revenues over the next two years, and just 3% are pessimistic. Roughly 80% are optimistic about profitability, according to an Economist Intelligence Unit poll of 1,300 executives in emerging markets at companies with annual revenue of at least $100 million.

"I am, despite the enormity of the financial crisis, more optimistic about the state of the world economy," Jim O’Neill, head of global economic research at Goldman Sachs Group Inc., told an emerging markets conference in London.

Because the U.S. economy no longer dominates the way it once did, O’Neill sees a bigger opportunity for the so-called  "BRIC" countries (Brazil, Russia, India, and China).

"It may be that the BRIC consumer is indirectly squeezing out the U.S. consumer," he said.

China is the most influential of all these markets because it is roughly the same size as the combined markets of Russia, India, and Brazil.

Original post

Comments

[megiddo666:]

Nice writeup and very pertinent.

What I find interesting is so many pundits have hollered "Stay out of China" based upon slowdown/global risk. However, I find it interesting that Goldman, Merrill, Morgan, Citigroup, and others, while liquidating some assets, have simultaneously plowed funds into Chinese water, infrastructure, food/grain/pork, and basic materials companies.

My take is -- if the major banks are investing in China in this environment -- why not the regular investor? Well, perhaps as usual the banks and funds are getting in cheap, then they'll let everyone else know so the PPS will be driven up.

When you can buy shares in some Chinese small caps with more cash than market cap, and single digit p/e's, that have major expansions underway, and will double revenues on their implementation in less than 12 months, why not buy?

2008 Sep 24 08:45 AM

[investor88:]

The logic is all there to buy China as this article and Ben's comments indicate. The rout in China's markets appears to present value and opportunity but another approach is to see an actual bull run before investing. This latter approach may entail losing out the initial sweet run but is a fair risk/reward trade-off because sometimes low can go lower.

2008 Sep 24 09:35 AM

[Larry House:]

Nice piece. We may both be wrong, but I agree with you. I have put money in a China fund as a multi-year holding. I think the China economy has the best chance of any to do well. After all, they will soon own us, so I want to own a piece of the owner; I don't want to lend money to the debtor.

2008 Sep 24 10:32 AM

[Loungin:]

While I agree that LONG TERM this is a great market to be in, there will be some more short-term pain. Retail sales in August were up, but let's wait to see September since many experts believe retail sales will show serious weakness since August retail sales were up due to olympics. Yes, 8 month numbers were up, but look at month over month and wait for September.

Real estate prices declined for the first time in a long time in August and are expected to decline again in September because of consumer confidence. Prices are plummeting. Sound familiar? I wonder how many loans in China are subject to real estate risk after the insane growth in 2007? Do you really think they weren't aggressive lending into the RE market?

The yuan continues to rise against the dollar. As we look to pay for this bailout the dollar will continue to weaken, sending the Yuan vs. dollar higher. This severely affects exporters since they become much less competitive in their major market, the U.S.

U.S. consumer demand is expected to be WAY down during the holidays, another major impact on Chinese exporters.

There are incredible short-term risks in China right now. I think the market is set to plunge in Q4 and even Q1 of next year. Then maybe we'll see a bottom.

Let's wait to see September statistics to see how strong the short-term really is. In the meantime, I'm sticking with my puts on FXI.

Follow Michael Pettis' stories on fake trades and major issues within the financial institutions. He has the exact opposite take on the situation and seems to be way more in touch with the market. Ride this Chinese market down until you're absolutely sure real estate and exporters have bottomed out. Until then, it is still a very risky bet to be long China in the upcoming months.

2008 Sep 25 01:36 AM

[James Lewis:]

What interests me is that everyone seems to have 'an all or nothing' account of what's is going to occur to China going forward. The truth is there are such imbalances present that there will be both very good and very bad things occuring.

In terms of infrastructure/water/c... energy/ecological/food safety industry and higher technology development. We will without doubt see unbelievable growth.

In terms of Industrial growth, exports will be down. However lets be honest they are declining from a very high level. We all knew this would not continue forever. But of course the downside is limited because as things stand consumers in the west are shifting to buyer cheaper products. And we all know where cheaper products are made.
Any decrease in exports will have a very serious effect on factories going under because of the huge overcapacity present in China. There will be a lot of bankcrupticies without doubt and of course this is negative for some of the domestic banks balance sheets. But because of the huge foreign investment in factories, we will see a lot of foreign factories going under. So the banking system will not have to take such a huge hit.

There will then be a lot of service businesses going under as well, because of the sheer overcapacity in the service industry. Anyone who has spent any amount of time in Shanghai knows that there is huge oversupply in restaurants/coffee shops/estate agents etc. As the chinese cut back their spending (which they will do going forward) a lot of businesses will go under. But this is a normal adjustment going into the end of the business cycle.

Real Estate has certainly slowed, but you know as yet in Shanghai and other big cities prime property is only a little soft.

2008 Sep 25 08:04 AM

[James Lewis:]

we are not seeing huge drops in property prices in good areas. In fact the best locations are holding their value. The new property is taking a hit in more outer locations, but it was overpriced anyway. So once again just a normal adjustment. Obviously there are some more serious issues with developers not being adequatly capitalised, but this will only mean going forward that the smaller developers will go bust. And projects will be eaten up by the bigger guys if it is worth buying. If it isnt then the property wont get built. Once again a normal adjustment to the oversupply of new property being built because of the boom times of 2007.

I understand a lot of peoples concerns that the banks have a lot of real estate on their books. But anyone who has purchased over the last 3 years has put at least 20-30% down due to government rules. Very different from USA/UK situation. There have been no fancy payment terms offered. In china you either get fixed (very rare) or floating exchange rate. So there are no resets etc to shock the market.

Because of the large down payments, there will not be the negative equity spiral which is what causes extreme price falls due to it being financially more rewarding to walk away then pay the mortgage. On this basis I expect good property to rise in good locations (in tier 1 cities) by around 10-12% by this time next year. Wild speculators have already been driven out of the market and I expect investors/banks that hold a lot of property on their books (banks through the use of fake client mortgages) to slowly de-leverage themselves by selling to people who want to buy property as homes. Good property in Tier 1 cities will be ok. But presents very little if any investment opportuniy because of the taxes/transaction/sell... costs.

I

2008 Sep 25 08:22 AM

[jmkeynes:]

Despite recent losses, emerging markets and commodities are still the best long term play.

If you don't like emerging market volatility, then consider selling out of the money, sort term, covered call options on ETFs such as EEM, FXI, EWZ.

2008 Sep 25 03:05 PM