China Investing:
Opportunities or Risky Bubble about to Burst?

This article was written in November 2007 - since then the China market has had a downward correction.  This article may continue to be of interest about how Investments are chosen and why the markets are so volatile. - May 2008


I believe there are good opportunities to invest in the ongoing growth of China, but very carefully to reduce the “bubble” risk to the extent possible. We recommend a small portion of a diversified portfolio with a growth objective be invested in China-related companies. International investing involves additional risks, including currency fluctuations, differences in accounting standards, economic and political instability, illiquidity and higher trading costs, and differences in foreign regulations, all of which are magnified in emerging markets.

While many economists predict overall that China’s growth rate will continue at 8-10%/year, for many companies selling in China you are seeing more like 18-20% growth rates in some of the major China cities, said Zachary Karabell of Alger Funds.

Down from its 10/16/07 high of 6057, as of 11/15/07 the Shanghai composite index at 5365.27 is still up 462% since 12/30/05 (1161.06) and is up 201% since 1/1/07 (2675.47).  The Shanghai Index P/E ratio is about 60 (similar to the height of the U.S. tech bubble.) But many of the companies can also be bought on the Hong Kong market, where the Hang Seng Index P/E is only around 16.

New China syndrome: Soaring stocks

Highlights from InvestmentNews 9/17/07

Some China fund managers said they expect the good times to keep on rolling — albeit at a slower pace. “We believe that the compelling case for investing in Chinese equities remains intact, based on very sound medium- to long-term fundamentals,” said Samantha Ho.

Even if that’s true, however, financial advisers said Chinese funds make them a little nervous. You have to look at the valuation of the stock market. Not all Chinese stocks, however, are overvalued.

A trend toward urbanization will benefit companies involved in infrastructure, but increased wealth among the Chinese will benefit other kinds of companies as well. “Our investment themes for China include consumption, infrastructure, financials, health care, environmental, as well as upstream sectors,” Ms. Ho said.

You Need Experience + Specialized Expertise to Invest WISELY in China!

Not only is company selection key in China but on what exchange and class of shares is important since valuations can be widely different.  For example, you need to know the difference in valuations, prices and restrictions to ownership between A shares, B shares, H Shares, S shares, P shares, red chips, green chips and purple chips.

Listed in Shanghai and Shenzhen, A shares and B shares trade at high valuations largely because too much money is chasing too few stocks. A shares are available only to local investors and outsiders accorded the status of Qualified Foreign Institutional Investors. B shares are open to foreign investors and locals with foreign-currency deposits. B shares in Shanghai are in U.S. dollars while those in Shenzhen are in Hong Kong dollars.

Many China companies listed outside the mainland trade at lower valuations. H shares are secondary issues floated in Hong Kong by a China-incorporated and listed company. WSJ 10/11/07 says mainland shares of the same company trade on average at about a 40% premium over H chips. Red chips are companies incorporated and listed in Hong Kong whose main assets and operations are in China. Singapore hosts a number of China companies, many of them owned by private entrepreneurs who could not list at home because the bourses give priority to state-owned firms. While not an official name some call them S shares. N shares are China companies with a secondary listing in New York in the form of American Depositary Shares. A number of China companies also trade in London in the form of Global Depository Shares.  Purples are what some people call red chip "blue chips" - the term for a well-established company having stable earnings and no extensive liabilities. Combine red and blue and you get purple.

 Confused?  That is why you need experienced expert management making these investment decisions.  We have recommendations we can discuss with you.

 Recommended China Strategy

 1)         Inclusion of U.S. based companies that are expected to benefit from China’s economic development and growth. Many U.S. companies are benefiting from international sales to an extent never before seen. For the S&P 500, 30 to 40% of profits are derived overseas; in some sectors and companies the percentage is much higher, especially in industries directly benefiting from China’s high growth rate and their emerging middle class. The weakness of the U.S. dollar is yet one more factor that has benefited U.S. companies doing business outside of the United States.

 2)         Inclusion of Asian-based companies not traded in the Chinese markets but who are also expected to directly benefit from the expected continued rapid economic growth of China because they sell goods or services to China, or have operations in China. For example, companies based in Hong Kong, Taiwan and Singapore.

 3) Seek managers with proven expertise and experience in Asian markets. Don’t invest like many of the locals based on lucky numbers and because neighbors made big gains.

 The Wild Chinese Market – Lucky Numbers Not Earnings Often Rule

There are over 100 million Chinese stock investors, as hundreds of thousands of new investors a month who mostly have no investment experience and simply hear they can make money by joining those already trying their luck. Individual Chinese have about $2.2 trillion is savings so there is lots of cash available for stock market investing.

 Risk Warnings Fail to Deter Novice Investors

Despite strong warnings from former Fed Chairman Greenspan that the Chinese rally is unsustainable and could suffer a "dramatic correction", Chinese investors pour into the market.  China's central bank governor, Zhou Xiaochuan, and Asia's wealthiest tycoon, Li Ka-shing, have issued similar warnings.

But at trading halls in Chinese brokerages, no one seems worried.  Millions of elderly pensioners, students, maids, Buddhist monks, and even young school children open new accounts. Some Chinese investors are borrowing large sums of money or pawning their possessions to buy stocks. Even Beijing putting a tax on share trades to cool the market bubble only resulted in a short-term market decline in May 2007.

Mr. Huang, a 71 year-old pensioner with little income is buying a computer so he can buy stocks online. "When everyone around me has earned money from the stock market, why shouldn't I invest in it?" he says.

Chinese investor confidence has been buoyed in part because many expect Communist leaders to do whatever it takes to keep share prices up and avoid a public backlash ahead of a key party meeting in late 2007, when new leadership posts are decided, and the Summer Olympic Games in Beijing next year.

As the Wall Street Journal reports, brokerages are set up like casinos: investors drink tea, smoke and chat as they make trades on computers set up like slot machines. Instead of dropping in coins they swipe bank cards to pay for shares.

The absence of a free press in China or regulatory controls leaves investors open to unusual trading theories. For example wearing red clothes represents a "hot" market and eating beef helps sustain the "bull" market.  They avoid references to "dad" since the word in Chinese is a homonym for "drop".

In Chinese society, homonyms of numbers hold deep meaning; especially the number 8 pronounced "ba" in both Mandarin and Cantonese - sounds similar to words for "wealth" and "fortune".  Consider the kickoff time for next year's Beijing Olympic Games: 8pm on 8-8-2008. Bank of China puts its trading floor on the 8th floor and China's tallest skyscraper and the Jin Mao Tower is 88 floors high.  Also 6 and 9 are lucky numbers but 4 is bad.  

So many investors look for numbers in the market, having no idea about the financial outlook for a stock.  When Tianjin Teda Co.'s shares traded at 19.48 Yuan the 8 was a lucky number to buy it at.

Market Bubble if bursts little impact on booming Chinese Economy

Growth is driven by exports which continue very strong and could offset any decline in Chinese consumer spending.  But it could destroy financially some of the Chinese new middle class if their investments have a large loss.

Summary

There are good opportunities to benefit from the ongoing growth in the China economy.  But you have to invest wisely, with proven experience and expertise.

 We are happy to meet and share with you our specific recommendations for a small part of a diversified portfolio if it meets your financial and investment objectives and risk tolerance.

The views and opinions expressed by Dave Hutchison, CFP are as of the date of the report, and are subject to change at any time based upon market or other conditions. The material contained herein is for informational purposes only and should not be construed as investment advice since recommendations will vary based on a clients goals and objectives. Information is believed to be from reliable sources; however, no representation is made as to its accuracy. All economic and performance information is historical and not indicative of future results. Please consult one of our financial advisors for more information. Hutchison Investment Advisors, Inc., is an Arizona registered investment advisor. Part II of Form ADV (Disclosure Statement) has been given advisory clients and is available on request.

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Last updated 5/7/2008

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