The Contrarian Case for Investing in China
Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Investors have been flying away from Chinese stocks lately, as many fear the possibility of an economic collapse in the country. China will need to implement many important reforms over the following years in order to achieve a sustainable development path in the long term, but right now its economy may be more resilient than many believe. Depressed prices for many Chinese stocks may be offering attractive entry points from a long term perspective.
There is an unquestionable slowdown in the Chinese economy; the country´s GDP growth rate is at three year lows near the 7.5% zone, and certain key indicators like industrial production, residential construction or electricity output are sending worrying signals. Given the outstanding velocity at which China has grown lately, there are some very vocal concerns about a possible economic breakdown in the country.
The chart compares the performance of the biggest ETF for China exposure, iShares FTSE/Xinhua China 25 Index (NYSEMKT: FXI) versus the S&P Depository Receipts (NYSEMKT: SPY) which replicates the S&P 500 index over the last two years. The image is quite clear on the relative underperformance Chinese markets have experienced versus their US counterparts.
The European crisis, combined with uninspiring economic growth in the US, could have a negative impact on Chinese exports, and that seems to be an important reason behind the many fears surrounding the evolution of the Chinese economy. But foreign demand has a much smaller role in economic growth than what many analysts believe to be the case in China.
Actually, net exports –exports less imports – have made a moderate contribution to China´s GDP growth over the last years. The key variable here is investment: spending on plant, machinery, buildings and infrastructure accounted for about 48% of China's GDP in 2011.
Most of this investment is done by State Owned Enterprises - SOEs – and this means that the criterion behind these decisions is sometimes not based purely on profitability, which leads to uneconomical decision making. As a prime example are the well-known ghost towns which have been built in many regions of China in anticipation of future demand.
Over time, China will need to move towards a more market based economy if it’s going to unleash the forces of innovation and productivity to truly join the capitalist world. But this doesn´t mean that a collapse is imminent or even unavoidable in the middle term.
The ghost towns and other kind of non-profitable projects are certainly a questionable strategy when it comes to the efficiency of capital allocation, but China finances these projects with local resources extracted from its own population, as opposed to unstable international capital flows.
The savings rate in China is above 50% of GDP, and that money is kept inside the country´s financial system via strict regulations, so there is plenty of liquidity to sustain investment rates. Also, central government debt is just 25% of GDP, which gives authorities a lot of dry powder to stimulate the economy by increasing fiscal spending and investing.
China will face some important challenges over the following years, and investors in the country should expect a wild ride as a repressive political system and an interventionist economic model crash against the free market institutions required for long term development. But just like the country was able to come out of the financial crisis much better than others by stimulating economic activity, authorities have the resources to do it again if necessary.
A breakdown in Chinese economic activity is not such a likely scenario as many believe, and the good news for investors is that many assets are already discounting such a possibility. FXI is trading at an average P/E ratio of 8 times, a very compelling valuation for an ETF investing in companies which should benefit from China´s rapid economic growth rate over the long term.
A similar P/E ratio is carried by Guggenheim China Small Cap (NYSEMKT: HAO), which may actually be a better alternative than its more popular alternative, FXI. This ETF invests in mid- and small-cap Chinese companies, it holds more than 200 securities and right now the biggest position is no bigger than 1.45% of the portfolio, so it provides adequate diversification.
Smaller companies have less exposure to heavily regulated activities like Energy, Telecom and Banking, and they are also a more direct way to bet on rise of the Chinese consumer. HAO holds more than 25.5% of its assets in the industrial sector, consumer (19.3%) and basic materials (15%) are heavily represented, but so is the unstable real estate sector with 12% of the portfolio. Also, HAO has a 3.2% dividend yield versus 2.7% for FXI.
China Mobile (NYSE: CHL) is the leading telecom company in China with an estimated market share above 66% and more than 670 million subscribers. The telecom sector in China is plagued with regulatory challenges, but China Mobile is offering interesting growth prospects due to its dominant position in the country´s telecom business. Also, the stock is attractively valued with a P/E ratio below 11 and a dividend yield of 3.7%.
For a high growth bet on China, Baidu (NASDAQ: BIDU) sounds like an interesting possibility. The Google of China is trading at a P/E in the area of 21, which doesn´t look excessive at all considering that China’s biggest search engine has delivered an extraordinary growth rate in earnings per share of 85% annually over the last five years. The online search business is very dynamic and subject to both technological change and censorship issues in China, but it also represents a very exciting growth opportunity for the long term.
There is a lot of pessimism surrounding China right now, and the country needs to implement important reforms if order to sustain a long term development trajectory. At current prices, however, many Chinese stocks are offering an interesting buying opportunity, especially if we consider the possibility that the country´s economy may be more resilient than what most analysts give it credit for.
acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Baidu and China Mobile. Motley Fool newsletter services recommend Baidu and China Mobile. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.