Goodwin Tells Bottom Line/Personal Why it's Wise to Invest in China

Why It’s Wise to Invest in China’s Growth Despite Major Challenges

Bottom Line/Personal interviewed Paul Goodwin, editor of the Cabot China & Emerging Markets Report. In the article published in the May 15, 2011 issue, Goodwin describes three powerful trends in China that are unlikely to be derailed by higher inflation or a slowdown in economic growth.

China is widely considered to be one of the most attractive and exciting long-term investment opportunities in the world. Last year, this nation of 1.3 billion people replaced Japan as the world’s second- largest economy and could surpass the US economy as soon as 2025. It already is the world’s largest exporter.

But after more than a decade of economic growth that averaged 9.8% per year and stock market gains that averaged 9.6%, there have been clouds in China’s investment outlook. Investors are asking whether China’s attempts to fight inflation by raising interest rates and taking other measures will slow economic growth to a drastic degree. That could have bleak consequences not only for investments in China but also in other emerging markets and in diversified foreign-stock mutual funds, as well as in US companies that buy from and sell to China. Bottom Line/ Personal asked emerging-markets investment expert Paul Goodwin whether China is still a great place to invest despite the challenges it faces and how best to do so....

GROWING PAINS

Over a three-month period starting last November, the Shanghai Composite Index plunged more than 14%, ending 2010 with a 5% loss for the year, compared with a 15% gain for the Standard & Poor’s 500 stock index. Reason: Investor confidence was shaken as China faced rapidly rising inflation. That inflation, officially an annual rate of about 5% recently, stemmed from factors including a red-hot real estate market...and the spiking cost of many commodities that China imports, such as copper and steel. The central government raised its benchmark short- term interest rates three times and will probably have to keep raising rates for months, which investors fear will crush economic growth.

These are all reasons for concern. But long-term investors shouldn’t panic. Although China’s autocratic government and companies can stifle innovation and competitive forces, I think the government will be able to steer a path that avoids both hyperinflation and a recession. In fact, the Chinese stock market is up about 3.5% so far this year despite additional pressures, such as soaring oil prices and much higher wheat prices due to a severe winter drought in China’s Northern Plains.

While there have been spectacular real-estate price increases in such major cities as Beijing, Shanghai and Guangzhou, China doesn’t face a credit bubble like the one that devastated the US banking system. It avoided that kind of crisis by imposing strict mortgage lend- ing requirements and not allowing the sale of derivatives, the packaged baskets of shaky mortgage loans that helped crush the US credit and real estate mar- kets and that Warren Buffett dubbed “weapons of mass destruction.”

What’s really happening is that China is going through big growing pains as it struggles to decrease its tremendous reliance on selling exports to the rest of the world and increase its own domestic consumer spending. In the next few years, its economy is likely to grow 7% to 10% a year—that’s still two to three times the rate that sluggish developed economies will achieve.

As an investor, it’s important that you have some exposure to China—which represents more than 10% of the world’s gross domestic product (GDP). The volatile pullbacks that will likely occur in the Chinese stock market this year will provide a good opportunity to pick up long-term bargains.

The best steps to take now to profit from China...

INVEST THROUGH US MARKETS

It’s hard for foreigners to invest in China’s public companies directly because foreigners are required to have expensive and scarce permits. Also, Chinese companies tend to have substandard accounting and financial disclosure practices. To avoid this problem, I choose investments only among the 200 Chinese companies whose stocks trade as American Depositary Receipts (ADRs) in the US. These ADRs, which represent ownership in shares of foreign corporations that trade in US financial markets, are denominated in US dollars. They offer a measure of safety because the companies issuing the shares must meet stringent Securities and Exchange Commission (SEC) approved account- ing, disclosure and financial-statement standards.

I also like US companies that have expanding operations in China.

Warning: Avoid index funds and exchange-traded funds (ETFs) that track the broad Chinese stock mar- ket. That market can be very volatile, and I don’t want to risk losing 65% as the Shanghai Composite Index did in 2008.

My preferred approach...

BENEFIT FROM THREE TRENDS

Focus on Chinese companies that are tapping into three trends so powerful that they are unlikely to be derailed by higher inflation or a slowdown in economic growth:

1. City living. China’s ongoing rural- to-urban shift is one of the largest human migrations in history. City populations and boundaries will expand by 20 million this year. Stocks that benefit...

Freeport-McMoRan Copper & Gold (FCX) is the largest copper miner in the world. More and more Chinese city dwellers desire the amenities of modern life, such as TVs, air conditioners and appliances. The average home requires at least 90 pounds of copper in electrical wiring and appliances, so it’s not surprising that the worldwide price of copper has tripled since the early 2000s. 

Yum Brands (YUM) is one of the largest fast-food restaurant companies in the world, with about $35 billion in annual sales from franchised chains, including Kentucky Fried Chicken (KFC), Pizza Hut, Taco Bell and
Long John Silver. It has vast potential for growth in China, which has far more young consumers than the US. For in- stance, KFC is the dominant fast-food chain in China. 

2. Trading up. Millions of Chinese workers are earning higher wages, joining the middle class and flexing their new consumer spending power by buy- ing homes, automobiles and computers and traveling more. The stocks that benefit...

Baidu (BIDU) is the leading Chinese- language Internet-search provider. Like Google, it makes its revenue through paid online advertising and has a virtual monopoly in its field. But Baidu has a much larger untapped market—77% of Americans already have access to the Internet, compared with only about 32% of Chinese. Baidu also holds more than a billion dollars in cash and has no debt.

China Yuchai International (CYD) makes diesel and natural gas engines for Chinese cars. In 2009, China over- took the US as the world’s largest car market, and in 2010, sales of vehicles in China jumped 32%. This company will benefit greatly from China’s tightening of emission limits. 

3. Building boom. The vast central and western regions of China are still largely underdeveloped. They need trillions of dollars of basic infrastructure, including raw materials, power generation, roads, rail lines, airports, and water and waste systems. The stocks that benefit...

Caterpillar (CAT) is the dominant global manufacturer of heavy construction equipment, such as bulldozers and excavators, and engines for off-highway vehicles. China already is one of the largest export markets for Caterpillar, with a total of more than $2 billion in sales there over the past five years. With 11 plants already operating throughout China, Caterpillar is likely to be the leading construction-equipment manufacturer there by 2015.

CNOOC (CEO) is one of China’s largest oil and natural gas companies. The Chinese are now the second-largest oil consumers behind the US, with a consumption rate that is growing seven times faster than in the US. CNOOC’s exclusive rights from the government to partner with foreign companies in offshore production in places such as Indonesia, Nigeria and Australia give it a huge advantage over all Chinese competitors. Economic growth in China will be particularly lucrative for CNOOC’s natural gas business as the government looks for a cleaner fuel to meet burgeoning energy demands.