China's $585 Billion Renovation

Includes: FXI, GSH, GXC, HAO
by: Guy Bennett

The global recession has hit China in a big way. Over 67,000 factories have closed in the last three months. An estimated 50 million Chinese workers are now unemployed, according to the usually overly positive government estimates. Protests or “mass incidents” are springing up all over the country.

The official Chinese GDP growth rate plummeted 30% in the last quarter. Independent data coming out of the manufacturing sector, however, suggests a much sharper decline. Chinese stocks have been surging up and down, just as they have in the U.S. There are ways to profit from this global market volatility. China certainly presents a unique set of opportunities.

The fact is, the Chinese have been running surpluses for 20 years. They hold about $2 trillion in foreign exchange reserves and they’re about to start spending it in a big way.

Earlier this week, China announced a $585 billion stimulus package to get its economy back on track.

We’ve been so used to hearing about multi-billion dollar bailouts and stimulus packages that it’s hard to absorb the significance of this announcement. But as a percentage of the Chinese GDP (around $3 trillion), this stimulus package dwarfs the U.S. bank bailout. In fact, it amounts to about 20% of its GDP, whereas the $1 trillion bank bailout amounts to about 8% of U.S. GDP.

Economic Stimulus

And guess what? China doesn’t need to borrow the money. It has around $2 trillion in foreign reserves.

Chinese workers are also great savers. They typically put 25% of their take home pay in low interest savings accounts.

Although China claims its economy is still growing at 6%, the data coming out of the manufacturing sector suggests this estimate is a bit too positive. You see, China is not a diversified economy. They make low cost goods (90% of the stuff at Wal-Mart (NYSE:WMT)) for foreigners. When those foreigners (mostly Americans) stop buying cheap stuff, the manufacturers are in big trouble, and when a crisis affects China’s manufacturing sector, it has the potential to grind all economic growth to a standstill.

China just can’t develop a mature, less-cyclical economy that way. For China to diversify out of manufacturing, they need to radically increase their domestic consumption. But that is not going to happen overnight.

So what is China’s short-term solution? Spend a massive amount of money improving the nation’s infrastructure, which has been critically lacking for some time. The money is slated for water and energy projects, roads, railways, airports and low-income housing. The Chinese government is hoping the infrastructure stimulus package will function as a bridge into China’s next economic phase, a more diversified, sophisticated industrial society.

We can think of China itself as a carpenter who’s been steadily employed for 30 years, and is suddenly fired. At first he panics: “What am I going to do with myself?” But, then he takes a few deep breaths and realizes, “Hey – I’ve got savings. And I’m a carpenter. What a great time to renovate my house!” Of course, this isn’t going to solve all the problems overnight, but nobody really expects it to.

Kirby Daley a Hong Kong financial strategist said:

The China stimulus package is not the answer to all of Asia’s problems, although it is a step in the right direction.

Foreign analysts had been expecting the Chinese government to make a dramatic move to shore up its battered economy, but few predicted anything on this scale. The day of the announcement, the Shanghai Composite Index surged 7.3%, but quickly pulled back as analysts pondered the effectiveness of the strategy. There is some skepticism about how much of the spending is actually new.

There also are complaints that the construction timelines are too stretched out to have significant short-term effects. However, it will have to provide some much needed help for China’s worst problem: unemployment.

The Chinese government can’t afford – politically or financially - to have laid-off factory workers sitting around twiddling their thumbs. Therefore, the work will be done and the money will be spent.

China has about 30,000 miles of highways and one million miles of county level roads. A great deal of this roadway urgently requires maintenance. It also needs new rail lines, power plants, and water infrastructure.

Here’s the thing - it’s a virtual guarantee China will use its own suppliers whenever possible to get this work done. Some U.S. companies, like General Electric (NYSE: GE) are predicting benefits from this spending. At Q1 Publishing, we are skeptical that these benefits will translate into more than a few extra cents per share for the major multinational conglomerates.

However, there are certainly opportunities here for investors. China is trying to help its own economy. If the rest of the world benefits – fine, and if not - that’s fine too. This is why we expect China to spend the majority of this bailout inside its borders. As a result, to capitalize on the spending, it’s best to own Chinese companies.

Most of the bailout package will be spent on the raw materials and service-suppliers needed to build roads, bridges, and other infrastructure. We should be looking at companies who operate exclusively in that space. Here’s a few we would consider pure-plays on China aggressive infrastructure spending:

West China Cement [LSE: WCC] is definitely going to be very busy. It produces and sells cement, using environmentally sound practices, under the brand ‘Yaobai Cement.’ It has three production lines in the Pucheng area (100 miles north of Xi’an) which can crank out 1.5 million tons of cement a year. A massive new plant, however, is scheduled to be completed in the next six months, bringing total production to 5.8 million tons. West China Cement had sales of about U.S. $430 million last year. Its profits and operating income increased about 70% from the previous year.

Guangshen Railway (NYSE: GSH) is a $107 billion transportation company poised to benefit from infrastructure spending in China. It has a fleet of passenger trains that operate between Guangzhou and Shenzhen, in addition to Hong Kong. The company also has a freight services division, which transports oversized cargo and construction materials. An estimated $100 billion of the stimulus package will be spent on rail services. Railcars are often referred to as “turn of the century technology” but in fact they are more energy efficient than cars, planes and boats. Guangshen’s operating income doubled in 2007 and their gross profit surged 163%.

China Railway Construction Corporation [HKSE: 1186] is an integrated construction company which provides infrastructure design and production in the areas of railways, highways, bridges, tunnels, airports and ports, water conservancy and hydropower facilities, real estate and municipal projects. This $20 billion company is on the “buy list” of many institutional investors. China Railway will benefit directly from the $585 billion in infrastructure spending.

Times are tough. To make money in these markets you have to be clear headed about the existing opportunities. When a big country like China announces that it is going to be spending 20% of its GDP building roads and railways, fortunes are going to be made for the companies China chooses to support.

I’m willing to bet China is going to support companies within its borders first. For that reason, we are keeping an eye on the political and economic shifts overseas and finding the companies that will truly benefit from the bailout, regardless of where they trade. In the meantime, there is a historically proven, conservative investing strategy that will help you to rebuild your portfolio.

Disclosure: None