China Opportunity - Still “The Next Big Thing”
China Investment Opportunity Review at 
www.China-AsiaStocks.com   

May 10, 2004
By Frank Liu 

It sounds a little bit odd to discuss the China opportunities at a time when investor euphoria for Chinese stocks has cooled down and the stock market has turned into search for the next “big thing” – seemingly to be Japan for many people.  

However, China is still too big to be ignored: 

-      Although for many years skeptics have been predicting China’s collapse, China’s economy has been growing at an average rate of above 9% since 1990. 

-      China is the sixth largest economy in the world in terms of GDP (some people believe that China’s economy is about half the size of US economy), but its contribution to the world economic growth in the past several years has been the greatest. According to World Economic Prospect report published last September by the International Monetary Fund (IMF), if calculation is made in accordance with PPP (purchasing power parity), in the eight years between 1995 and 2002, the percentage of the value of US increased GDP in the global economic growth was 20 percent, that of the EU 15 percent, that of Japan 2 percent, and that of China was as high as 25 percent.  

-      In 2003, China accounted for 7% of global crude oil consumption, 27% of the steel used in the world, 31% of the coal and 40% of the cement, and it is now the world's biggest consumer of copper, after passing the United States in 2002. Its rapidly growing demand for energy and base metal was a significant force behind the price hikes in the world commodity markets last year. 

-      China's total import and export trade value ranked eighth in the world in 2000. In 2002, it placed fifth, and in 2003, it was third, ahead of France and Japan and just behind US and Germany. 

-          China is currently the fastest-growing export market for many countries around the world, particularly the Asian economies – last year, China accounted for 68% of export growth in Taiwan and for 36% of export growth in South Korea. Even Japan should thank China for giving it a big lift on its recent economic recovery, because China’s boom has provided strong demands for Japanese products at a time when exports to US, Japan’s largest single market, have been declining.  

China is such a big thing that it is worth investors’ attention in the many years to come, and not just in the past year when the market seemed to suddenly “discover” the China opportunity. 

China will keep growing 

Many investors are concerned that China’s boom may be overheating and the Chinese government’s measures in slowing down the economy will eventually lead to a “hard landing”. Some people are even talking about a total collapse of China’s economy - as many skeptics have been predicting for years. In the past few weeks, this concern has put significant pressures on the Asian stock markets and sent commodity prices lower around the world. 

Personally I believe China’s tightening on the banks’ lending is good news and will retain China’s economy at a steady and relatively fast growth level. A big reason for China’s huge jump in last year’s fixed capital investments was related to the plan of selling its largest commercial banks overseas. To make their financials look better the banks have to cut down their unusually high non-performing debt ratio. A quick way to do so is to increase their assets, denominator of the ratio, by issuing more loans. The Chinese banks are issuing new loans so quickly with no effective screenings that they will eventually result in even more bad loans, most likely, from loans issued to overheating investment projects such as steel, aluminum, cement, and real estate. 

By tightening lending to the overheating industries China will release some air from the potential economic bubble, and avoid a painful hard landing. It is a good thing for China’s economy - at the right time. 

A few more things worth consideration in predicting China’s economic trend: 

(1)     China’s credit-tightening measures only apply to several overheating industries as mentioned above; the central government still encourages capital investment in the industries China desperately needs most: coal, electricity, oil & gas, transportation, and water supply. Many projects in these industries are still going ahead as planned, and they will be significant driving forces in China’s economy growth.

(2)     China is still the No. 1 country in attracting foreign direct investment. Companies all over the world, large and small, are diving into the country, either targeting at China’s growing consumer market, or aiming at lowering their production costs, or trying to do both. Foreign investors bring in billions of dollars to fuel China’s economic boom and there is no sign of slowing down in this trend.

(3)     China simply can’t afford a sudden slowing down in its economy: creating more jobs and lowering the already painfully high unemployment rate is the priority of the central government. The government will do whatever needed to keep the economy growing at a healthy pace.

(4)     China is determined to narrow the gap between its more developed eastern region and the more rural western region that has been dropped behind. While the western region has been supplying energy and mineral products to the eastern region, its huge consumer market historically ignored by companies in the eastern region is now attracting more and more wealth seekers into it, and creating a demand for upgrading its infrastructures.

(5)     A rapidly growing number of private business owners have accumulated a large amount of capital, either through their business operations or by selling stocks in the public markets. These private business owners have been constantly looking for new investment opportunities, and they are backed up by their increasingly strong ability to fund from their own pockets.

(6)     Finally, when the rest of the world, particularly US, has seen signs of higher economy growths, it’s almost impossible for China to be left out.  

Taking all the above issues into consideration, although investments in certain industries will be affected by China’s recent bank credit tightening measures, it is very unlikely to see a sudden slow down of China’s investment activities in 2004, and probably we won’t see it in 2005, too. As China’s economic growth has been driven by capital investments, it will keep growing at a relatively high speed as long as investment activities continue to boom.  

Indeed, many institutions around the world, including Asian Development Bank, have recently forecasted that China’s GDP growth to stay above 8% in the coming two years. Meanwhile, in one of its reports, J.P. Morgan predicted that China will successfully achieve a “soft landing” in its overheating economy. 

Looking into the longer future, China’s economy will certainly face tough problems at some point and it requires great talents to keep everything in balance. China’s approach is to solve these problems gradually, with the help from accelerated privatization and rapid economic growth.  

I can not predict whether these problems can be solved gradually without serious damages to China’s economy. But one thing is for sure – 1.3 billion people in China have the desire to live a better life. They are quick learners and they are going to find their way to wealth. So even though China may experience ups and downs, it will continue to be an economic powerhouse and 
keep growing – for a long period of time.   

Be part of the growth, but be prepared

A well diversified equity portfolio will reduce the amount of risks and produce a higher risk adjusted return. In my opinion, a diversified world portfolio should have investments focused in three regions: North America, Europe, and Asia. Unfortunately, most world equity portfolios we see in North America have over half of their investment in the US market, and only a very small percentage in Asia. And when it comes down to Asian markets except Japan, the weight is usually just a few percentages.  

These are not well balanced world portfolios. I would recommend people to put more weight on Asian stocks, particularly the emerging markets as represented by the greater China region, because the cost of missing the world’s fastest growing opportunity is expensive. 

The recent retreat of market interest in China related stocks and commodity prices (mainly driven up in the last year by the “China story”) is indeed a very good thing for investors who want to be part of China’s growth in the long run, because the cooling down gives them more time to pick the right assets as well as the opportunity to get involved in China’s economic expansion at a more favorable price. 

China Region Funds 

For an investor in US to get some China exposure, the best way to do so is to buy a China fund. The reason is simple: it’s easy.  

Most China funds have over half of their money invested in Hong Kong because it is a more mature market compared with Mainland China, and many Mainland China stocks are listed in Hong Kong (H-shares). Another market that has a large share of a fund is Taiwan. Taiwan has a close economic tie with Mainland China and it is a more mature market as well. 

Things may change when more “Qualified Foreign Institutional Investors” are approved to enter China’s domestic stock markets and purchase A-shares traded in Chinese Yuan. A-shares give foreign investors more choices of Chinese stocks and provide them the access to many industries that they can not get into by investing in H-shares. 

Investors may choose from a group of Greater China region mutual funds: Mathews China (MCHFX), Dreyfus Premier Greater China (DPCAX), US Global Investors China Region Opportunity (USCOX), Columbia Newport Greater China (NGCAX), AllianceBernstein Greater China (GCHCX), Guinness Atkinson China & Hong Kong (ICHKX), and Fidelity China Region (FHKCX).  

Some closed-end investment funds traded on US exchanges are also available: JF China Region Fund (JFC), the China Fund (CHN), the Greater China Fund (GCH), and the Templeton Dragon Fund (TDF).  

My advices:

-          Wait a little bit longer. China region funds have been suffering huge outflows since April, but there seems to be more room for them to go down; therefore it is still not the best time to buy those funds. When you see a deep discount on Net Asset Value of those closed-end China funds, it may be the time to get in.

-          Some of those funds have been doing better than the others, but their historical performance should only be used as a reference.

-          Shop around for the best fee structures. 

Chinese Stocks Listed on US Exchanges 

There are about 50 Chinese companies listed on US Exchanges in the form of American Depositary Receipts, and a few more incorporated in US but with their core business operations in China.  

The good thing about buying a Chinese stock listed on US Exchanges is that you have a direct investment in China but at the same time you don’t have to deal with company information released in Chinese, a language you may never want to learn, or scratch your head over the financial statements prepared with Chinese standards, which you may have a question on how different they are from US accounting rules.  

But the transparency problem still exists. For example, China Life Insurance (LFC) is now under investigation by SEC over the company’s failure to disclose several accounting irregularities before its US3.46 billion stock listing in New York in last December, the largest and one of the hottest IPO’s worldwide last year. The accounting scandal weighing over China Life Insurance has increased investors’ concerns over the lack of proper corporate governance and regulatory controls in China. 

However, there are some really good Chinese companies listed in US, and their price declines following the recent retreat of market interest have provided investors some excellent buying opportunities. For those China believers, the following Chinese stocks may be worth closer attention: 

China Eastern Airlines (CEA) – one of the top three air carriers in China. Based in Shanghai, the company is a beneficiary of the country’s rapidly growing business travel and tourism market. It may also benefit from China’s airline industry deregulation and consolidation. Air travel in China is estimated to jump 30% this year and maintain a double-digit growth for years. In the short term, a higher fuel price could hurt the industry’s gross margin, and the potential of another SARS outbreak in China, although seems to be very small, is also a threat. Nevertheless, this stock gives you an excellent exposure to a fast growing air travel market in China. Suggestion: Long-term buy. 

China Mobile (CML) – the largest mobile telecommunication service provider in China. China is currently the biggest mobile market in the world. Its growth prospects in the long run remain solid given the fact that the penetration of cell phones in China is still relatively low. With its recent plan to acquire its parent company’s major operating assets, China Mobile will become the first nationwide Chinese wireless carriers available to public shareholders. Although its profit growth may slow down this year due to its preemptive move into poorer regions where a lower margin is expected, it is probably still the best pick for investors who want to get into China’s wireless telecommunication market. The stock still has some downside room in the short term, but it currently looks reasonably priced after losing 25% from its recent high around $18. Suggestion: Long-term buy. 

Linktone (LTON) – the company provides entertainment-oriented wireless value-added services to mobile phone users in China. It has two tier one customers: China Mobile and China Unicom, the top two wireless communication providers in China. Linktone’s business has been growing at a remarkable pace: in 2003, the company’s revenues totaled $15.5 million, up from $4.4 million in 2002. Net income to common share holders totaled $3.5 million, compared with a loss of $644,000 a year ago. The company is well positioned for another great growth year in 2004, but investors’ ire on Chinese companies has sent the stock to around $8 a share, half way below its offering price in early March. There are signs of oversold. Suggestion: Speculative buy. 

Shanda (SNDA) – an online gaming company scheduled to be listed on New York on May 11^th. The company has been a leader in China’s relatively new online gaming industry. China’s broadband internet-based online gaming market is still very young. Last year, the number of internet users in China increased by 40%, but of the total 80 million internet users in the country, only 17 million had broadband connections. The growth potential for broadband internet market in China is obvious. According to the estimate of International Data Corp, last year there were 15 million online game players spending $160 million in China. In 2005, the number of players will reach 54 million, with a spending of $823 million. Last year, Shanda had $76.5 million in revenue, and a net income of $33 million. This is an attractive company doing very well in an attractive market. Although the company is facing more competitors attracted into the market, online gaming in China is still young and can accommodate some more players. Suggestion: Watch closely on its performance following IPO. 

Please check the website www.China-AsiaStocks.com for more Chinese stocks listed on US exchanges. 

Stocks That May Be Influenced by China’s Growth 

You don’t have to buy a China fund or be a shareholder of a Chinese company to get involved in China’s economic expansion. There are some alternative ways to do so for a US investor: to invest in non-Chinese companies that may benefit from China’s growth, either directly or indirectly, and avoid companies that may suffer from increasingly strong competitions coming from China. 

What does a growing Chinese economy really mean to the world?

-      A growing demand for energy as a result of industrialization

-      A growing demand for raw materials as a result of industrialization

-      A growing demand for cleaning up the pollutions caused by industrialization

-      More prosperous international trade activities and increasing demands for cargo transportation

-      A growing market for better foods and agricultural products as a result of rising standards of living coupled with decreasing size of farmable lands

-      A growing consumer market for anything you have been used to in America but that is still rare in China

-      A rapidly growing and really fast learning manufacturing sector which, with the unbeatable cheap labor advantage, can force many manufacturers around the world into closing doors.  

With the above pictures in mind, you will feel a lot easier to implement your “play China” strategy.  

Energy and Raw Materials

Take China’s demand for energy as an example.  

China’s fast pace in industrialization has created a huge demand for energy. This year, China will likely surpass Japan as the world’s second largest consumer of oil, only after US. But the per capita use of oil in China is just 1.7 barrels a year, compared with 30 barrels in US, and close to 20 barrels in Japan and South Korea. With a strong demand but limited oil reserves in its own ground, China has become increasingly dependent on oil imports. Last year, its imports of crude oil jumped 30%. Now, China imports a third of its oil, and the US Energy Information Administration forecasts that by 2020, China will import two thirds of its oil, or 7 million barrels a day, over a quarter of today’s OPEC production.  

The country’s thirsty for energy also created a huge demand for coal and natural gas. In 2003, the nation’s consumption of electricity increased by 15.4%, compared with 11.6% and 8.7% in 2002 and 2001 respectively. But there is no sign of slowing down in this trend: in the first quarter of 2004, the consumption of electricity increased by 16.4% over the same period of last year. The country has been suffering from severe shortage in electricity for years. This year, China is expected to have a shortfall of at least 20 million kilowatt in electricity supply. Many places, more accurately, 21 provinces out of 31 in China have experienced blackouts last year because electricity was cut off at peak times. The situation this year is expected to be worse. This rapidly growing demand and a lag in supplies have encouraged the launch of a series of new power plant projects, and most of them will be coal-fired plants. It is estimated that over the next 25 years, nearly as many coal-fired power plants will be built in China as in the rest of world combined.  

With increasing concerns over the heavy pollution cased by coal-firing power plants, China has been promoting more use of natural gas. In 2004, a total of $17.3 billion will be invested in East China Sea to build 10 natural gas platforms. But that’s far away from enough. According to an estimate by China National Offshore Oil Corp, China’s demand for gas will be growing at 12% a year for the next 15 years, reaching 160 – 210 billion cubic meters in 2020. By then, half of China’s gas will be imported. 

This trend in China’s demand for energy will not change soon. This is a huge thing in the picture of world energy demand and supply. In the case of oil, many experts around the world have concluded that most of the world’s oil supplies have reached their peak outputs, because the age of the world’s core oil supply is already old, and no super giant fields have been found since 1975. For coal, there are abundant lower grade coals in the world, but not many good coal supplies. And for natural gas, the conventional gas supplies have peaked, and it takes years for unconventional gas wells to develop. 

All the factors lead to one conclusion: a long-term bull energy market in the many years to come as demands from China and other developing countries keep growing strongly. 

The situation with raw industrial materials, particularly base metals, is similar to the energy sector, as proved by the soaring commodity prices last year. Investors’ expectation on China’s huge demand for industrial materials was a major driving force behind these price changes. Since earlier this year, commodity prices have been eased as the “hot money” is moving out of the sector, but that does not change the long-term upward prospects of industrial commodities. Supplies of many industrial commodities have not increased since the long lasting bear market started in the 1980’s and it normally takes a cycle of 5 to 10 years for a mine from exploration to reach a meaningful production capacity.  

The best strategy to benefit from the bull energy and commodity market is to buy in oil, gas and mining companies with large reserves, because commodity prices are so volatile that an investor can easily get burned. By investing in oil, gas and mining companies investors can benefit from the rising energy and commodity prices on a much smoother ride.  

Recommendations: Investors could find some good energy and mining companies from resource rich countries such as Canada and Australia. I recommend two of them: Esprit Exploration (EEE.TO) and BHP Billiton (BHP). 

Please check the website www.NaturalGasStocks.com for more natural gas stocks. 

Alternative Energy, Energy Efficient Technologies, and Environmental Products

As China’s industrialization going on a fast track, Chinese have realized the harm it could bring to the environment. At the current growth rate of coal consumption, China will overtake US as the world’s leading greenhouse gas emitter by 2030. To prevent this from happening in reality, China has been looking at the choices of cleaner energies and more energy efficient technologies.  

Some companies in this category have been pretty active in China. I recommend one from Vancouver, Canada: Westport Innovations (WPT.TO). This company is a leading developer of gaseous fuel engine technologies. Through Cummins Westport Inc., its joint venture with Cummins Inc (CMI), the company develops, manufactures and sells a wide range of engines for commercial transportation applications such as trucks and buses. Beijing Public Transportation Corporation from Beijing, China has been a royal customer of Westport and has purchased over 2,000 Cummins Westport engines over the past several years. But Westport is positioned to have a bigger shot in this market: Beijing’s current transit fleet has 13,000 buses. By 2008 when the Olympic games are held in the city, there will be 18,000 buses – equal to 30% of the total transit bus market in US. Beijing is trying to clean up its air quality before the Olympic games by replacing its transit fleet with cleaner engines, and this will be a great news for Westport. 

Please check the website www.RenewableEnergyStocks.com and www.FuelCellCarNews.com for more stocks in this category. 

Foods and Agricultural Products

As for foods and farm products, China’s demand has also become a bigger influence in the world market. For example, last year, China purchased 13% of soybeans grown in US, and it has been importing more wheat, milk, beef and cows – if you pay a visit to a dairy farm in Australia or New Zealand, most likely the owner is busy with planning how many more heifers he could export to China next year. 

China’s growing demands for foods and agricultural products have created some excellent investment opportunities in the food and farming industry. But an investor should be aware that the cycles of supplies for most agricultural products are much shorter than mining products. 

1.3 Billion Consumers

China has the largest consumer base in the world: a population of 1.3 billion. Huge success of early movers such as fast food chain giants McDonald’s and KFC and cell phone producer Motorola has seduced many followers diving into China’s consumer markets – perhaps too many. Take the auto industry as an example, in 2003 alone, the number of passenger car makers in China increased by 12, which represents a leapt by 60% from 2002! According to a prediction of the country’s National Development and Reform Commission, the nation’s vehicle manufacturing capacity could reach 15 million in three years, while the consumer demand will only be 7 million.  

Now, banks and insurance companies around the world are heating up for competing in another market almost untouched by foreigners: financial markets. Taking the credit card market as an example, early movers into China include HSBC, Citigroup, and American Express. It is still too early to predict how well they may be doing in China. But one thing is for sure: their revenues in the China market are unlikely to affect the companies’ total revenues pretty soon. For this reason, I can not recommend any of them just simply based on the fact that they have a presence in China at this stage. 

Avoid what China has

I like a popular saying on how to play China through investing: buy what China wants; avoid what China has. 

It is so true when you think of the energy and raw material sector – what China wants, as we have discussed earlier. 

It is also true when you think of China’s strong manufacturing sector – what China has. China’s growth may experience ups and downs, but its manufacturing facilities will just keep running, producing everything from more labor intensive goods such as kitchen utensils and clothes to more technology intensive products such as electronics and recently, cars and trucks – at a cost way lower than many Americans can imagine. So, if you are considering buying, say, a US barbeque producer’s stocks, think again – Chinese can make the same barbeque for a fraction of the cost of an American made one. 

Even worse, when China’s economy is not doing well and their domestic demand growth slows down, its manufactures tend to sell harder outside of the country. No wonder automobile manufactures around the world are having bad dreams now: think of the overcapacity in China’s auto industry: where will the 8 million overproduced vehicles end up?   

Conclusion

Like it or not, China will be a big part in your investment decisions. You may choose to participate in China’s growth, or you may choose to avoid its impact. In the case you want to be part of its growth, please look long. China’s economy may experience short term slow-downs, but in the long run it has great upside potentials. There are different ways to invest in the China opportunity; be prepared, knowing what you want and when to get them.   

Mr. Frank Liu - Research Consultant, CFA

Frank Liu is a CFA Charterholder. He also holds a MBA from University of British Columbia in Canada and a Bachelor of Economics from University of International Business and Economics in China. Having served both public and private companies in Canada and China, Frank Liu currently works as an independent business and investment consultant, providing industry research, business assessment and financial advising services to clients from Asia and North America.  Feedback: fliu@investorideas.com  

Disclaimer:
InvestorIdeas.com and/or www.China-Asiastocks.com did not receive compensation from any of the companies in the report and has no direct affiliation with any of the companies in the report.