From the September 2012 issue of Investment Advisor • Subscribe!

New China: Investing in a Growing Global Leader

After a generation of remarkable growth, what’s next for this economic powerhouse?

Illustration by <a href="http://www.crackedhat.com/">Robert Carter</a> Illustration by Robert Carter

Fifteen years ago, when Mark Mobius, executive chairman of Templeton Emerging Markets Group, first visited China, the swath of land across from Shanghai’s historic waterfront, the Bund, just lay there. Today, he says, that same place is a glitzy urban center, populated by skyscrapers that can rival, if not surpass, any of those that tower above the ground in the world’s largest metropolises.

“In just a short period of time, they’ve transformed what was essentially farmland into a major city, and this kind of construction just continues everywhere in China,” Mobius says. “It’s exciting to see that happening, to see the infrastructure that’s being built, to see the offices and the apartment buildings coming up. It’s just going to continue.”

For Mobius, the forecasts for a slowdown in China’s economic growth are inconsequential. The most dire of pessimists are forecasting a 7% growth rate for the country (Mobius is betting on 8% to 8.5%), but in today’s world, where nations are falling apart, that’s still a pretty impressive figure, he says. Not to mention that “the Chinese government has many policy tools that are not available to other countries, including a tremendous banking sector that they can rev up in order to increase lending, $3 trillion in foreign currency reserves, an economy that continues to attract foreign investment and a population that has high savings.”

The percentage of exports going from China into developed nations may be declining, but the demand for products and services within China is increasing. For a dedicated investor like Mobius, it’s particularly exciting to see manufacturers that have focused on exports now set their sights on the domestic market. It is this next wave in China’s growth trajectory that he’s going to capitalize on through investing in multinational companies, as well as local players that are going to play an important role going forward in the Chinese economy.

“As China emphasizes domestic consumption, the economy is going to accelerate again, and it’s going to be very attractive for foreign investors, both direct as well as portfolio investors,” Mobius says. “The demand for products in China is growing exponentially, whether that’s for BMWs or Volkswagens, for leisure and travel, or fast food—it’s all expanding very rapidly.”

Mobius’ focus on the consumer sector is one that a growing number of investors who believe in the long-term potential of China as an investment destination share. He is also bullish on commodities, a sector now out of favor largely because of the China slowdown, but one that’s undoubtedly going to come back, fueled by domestic growth in China.

“The consumption of oil by emerging markets is almost equal to that of developed nations, and China is a big part of that,” he says. “Chinese companies need coal; they need oil, and as the demand for consumer goods like washing machines, air conditioners and fridges soars in China and other countries like India, you’re going to see an increasing demand for power.”

It goes without saying that today—and Mobius would be the first to admit it—investing in China is no great secret. But how one does it is what’s important. There are many IPOs coming out of China, and Mobius believes that separating the good opportunities from the bad is one of the greatest challenges that investors today face. But he also believes that going the extra mile and researching them properly and thoroughly, and looking at China beyond its obvious, gigantic stature in the global economy, is what’s going to take investors forward to where the opportunities really lie.

The experts featured in this story have all had long relationships with China and have watched with admiration as the country has grown and transformed. Here, they share their investment philosophies and approaches to zeroing in on the best opportunities that China’s focus on domestic growth can offer.

Brien O’Brien, CEO, and Jonathan Brodsky, managing director, Advisory Research Funds (ARI): Quick In, Quick Out is the Way to Go in China

Driving around the Southern Chinese city of Shenzhen today feels very much like driving around Newport Beach, Calif.—give or take a few years.

“There are palm trees everywhere. Everything is brand new, exciting and vibrant,” says Brien O’Brien, CEO at ARI. “It’s impressive to think that just 15 years ago, most of these cities were little more than one-horse towns.”

Cities like Shenzhen are not only a testament to the impressive economic and structural changes that have taken place in China over the past years, they are also the result of the tremendous amount of wealth creation that has happened and continues to happen there—an important facet of the Chinese economy that’s particularly exciting to O’Brien.

“It’s been very interesting to see a communist country become the Wild West of capitalism,” O’Brien says, “and that’s given me some very good feelings about investing there.”

Although O’Brien has little doubt about China’s potential as a long-term investment opportunity, he is also the kind of investor who believes he’s better off with a quick in/quick out kind of investment strategy: one that doesn’t bind him in any lasting way, but still makes the most of various opportunities that come with increased wealth generation and changing consumer tastes.

“The political structure, the rule of law in China—they’re not very comforting to me, and I don’t want to have to subject myself to them,” he says. “That’s why I don’t want to create real assets in China, but rather use the economy to my benefit.”

That means having as little as possible to do with sectors of the economy that the Chinese government is involved in, but everything to do with businesses that evidence the best of the consumer-driven economy China is increasingly becoming, in both a direct and indirect way. ARI sees the best opportunities in companies that are listed on the Hong Kong, Tokyo, Singapore and U.S. stock exchanges—companies that have strong links to China in terms of revenue generation, but are not in sectors where the government has a large say.

Companies like Yue Yuen, the largest global manufacturer of footwear for premier sports brands Adidas and Nike, is a prime example of what ARI is looking for in its China exposure. With a $5.5 billion market cap, a modest PE ratio of around 10 times and a very strong balance sheet, the company’s business is booming because of the very high demand for Nike and Adidas apparel in China, says Jonathan Brodsky, managing director at ARI.

“So instead of buying Nike and Adidas directly, we buy Yue Yuen as it relates to consumer growth in China,” Brodsky says. “The company is also very well-run and has a high level of transparency because of its relation to Adidas and Nike.”

Japanese food company Hokuto is another business that fits ARI’s needs. Hokuto is Japan’s leading producer of high-end specialty mushrooms and has invented several kinds of very specific mushroom types that are integral to Chinese food.

“The company has warehouses in Taiwan, and we see Taiwan as a window to long-term opportunities in China,” Brodsky says. “We also believe that the consumption of these specialty mushrooms in China is going to explode, as people have more money to spend on food and other things.”

Being able to scout around for opportunities like Yue Yuen and Hokuto—high-quality businesses that benefit from a stable and increasing supply of orders, and that produce goods they can sell in the Chinese market—is key to getting the best out of China, O’Brien says. They are also not likely to be as affected by the general slowdown that’s been forecast for the Chinese economy.

“We feel that even with slower growth rate forecasts, the China dynamic is in place. Even if it’s not going to be as smooth a trajectory as everyone would like, we don’t think that the consumption dynamic is going to be affected,” he says. “Nevertheless, we do want to stay away from government influence and look to the individual consumer. We look to align ourselves closely with local shareholders and management teams, investing in companies with high levels of corporate governance and financial transparency.”

Robert Horrocks, CIO, Matthews International Capital Management: Individuality and self-expression are growing in China

Robert Horrocks, CIO of Matthews International Capital Management and manager of its Asian Growth and Income Fund (MACSX), first visited China in 1987 while a student at Leeds University in the United Kingdom to study modern Chinese at the University of Beijing. Since that time, he’s been to China frequently, and he’s most impressed by what he terms the “individuality of life” in China today.

“There are many obvious changes—modern buildings, modern cars, book shops, malls and so on—but to me, China today is about expressing one’s individuality in a way that one could never express it before,” he says.

Life in the Old China had very little, if anything at all, to do with individual capabilities, skills and choices. Today, self-expression is key, and that translates into the way people dress, eat, play sports, travel and entertain themselves.

“The change is tremendous because it allows for the creation and growth of all manner of very profitable opportunities,” Horrocks says. “New ventures that provide products and services for a new lifestyle in which people are looking to express their individuality. I believe that change is only going to continue.”

Matthews focuses its China investment strategy on companies that can offer consumers a more self-expressive and explorative lifestyle. Whether it’s through retail or branded goods, media or health care, there are myriad ways one can tap into this dynamic, Horrocks says.

“You have to think about how the family is changing and examine that dynamic,” he says. “As people are able to express themselves more freely, they may want to spend more money on leisure, for example, and less on caring for the elderly. As families in China become more like nuclear families in the West, there are wide ranging implications for self-expression.”

But focusing on the importance of self-expression in China as it mirrors the social and economic changes that continue to happen there also means looking beyond the obvious.

“Take an area like wealth management: As people have more money, they want to invest it into different kinds of financial products,” Horrocks says. “And as people get wealthier, they begin to care about other things, like the environment; so, in thinking about how consumer preferences are changing in China, investors who are looking ahead should also be looking at companies that make a more efficient use of energy resources, materials and so on.”

Bearing in mind the general theme of changing consumer habits and tastes, Matthews also places a great deal of emphasis upon assessing individual companies in a nuts and bolts manner. The broader dynamic is very important to the firm’s overall China investment theme, Horrocks says, but understanding each and every business is key, particularly with respect to how it fares vis-à-vis shareholders.

“Much of what is done in China is done in Hong Kong, which has a very well-established stock market, strong auditing and a proper anti-corruption bureau,” Horrocks says. “Hong Kong is a very well-developed and familiar kind of environment for us.”

The company also looks to dividend-paying companies in China—not an obvious strategy for many, Horrocks says, but definitely one that Matthews believes will pay off in the long term.

“Dividend payments are a very good check on corporate governance. If a company is paying a dividend to its shareholders, that means it’s using cash in a useful way and is probably a well-managed business,” he says. “People don’t immediately think of China as a place where a dividend-based investment strategy can work, but we have been implementing dividend investing throughout Asia, and we are pretty certain it’s a worthwhile strategy for China, too.”

Matthews launched its dedicated China Dividend Fund (MCDFX) in 2009.

Brian Gendreau, market strategist, Cetera Financial Group: Valuations and Wealth Creation Should Invite Investment

Few would argue that China’s popularity has resulted in Chinese stocks becoming overvalued. However, forecasts for lower growth have reduced Chinese stock prices quite a bit, says Brian Gendreau, a market strategist at Cetera Financial Group. That means buying China based on valuations alone is as good a reason as any other to take advantage of the opportunities there.

“The market went through a process of pricing down China because of the economic forecast, but what’s important to note is that the relationship between GDP growth and equity markets is almost always non-existent,” Gendreau says. “China may only be slated for 7% to 8% growth this quarter, but most countries would still die for that. My guess is that people who buy China now will be very happy three to five years down the road.”

Consider that the price-to-book ratio for the Chinese stock market is about 1.7 and its trailing price-to-equity ratio is about 10.8, compared to 12.8 for the United States and 12 for emerging markets on average. Looking ahead, that number is forecast at 9.2, which is even better, Gendreau says, so it’s tough to argue that China is overvalued at this point.

Given the metrics, those who buy China now will reap returns in the future if they believe, as Gendreau does, that the forecasts for economic slowdown are only temporary. China is still the engine for world growth, but more importantly, domestic demand is the engine for Chinese growth, and that will continue to increase.

“China has turned away from manufacturing and is focusing on domestic demand,” Gendreau says. “China has exceeded the [United States] in terms of wealth, and that’s a huge factor supporting domestic growth in a country where demand for everything from BMWs to Big Macs keeps increasing.”

Growth may be slowing now, but the way China is developing means opportunities will always arise in tandem with expanding consumer demand. For investors getting in now, the prospects look quite good.

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