China Stock Digest Research and Investment Opportunities in China Articles

China Investment - Beijing Olympics 2008
CHINA GOES FOR THE GOLD

At precisely 8:08 PM on the 8th day of the 8th month of 2008, the opening ceremonies of the Beijing Olympic Games began, marking the biggest coming-out party in the history of China, the world's most populous country. It broadcast an unmistakable message to a worldwide audience of four billion viewers.

There was great significance to the timing of the ceremonies. 8:08 8/8/08. Those numbers symbolize China's economic success. The number eight is pronounced "ba" in Chinese, very similar to the sound of the word "fa", which means wealth. Great wealth to be exact.

The Olympic Games, especially the opening ceremonies, were a showcase for the world's fastest growing major economy. From the fantastic "bird's nest" stadium to the lavish Olympic facilities which were all but complete prior to the games, China staked out its territory as an unprecedented success story on the world stage. Like the Seoul Olympic Games of 1988 and the Tokyo Games of 1964, Beijing was chosen as a venue by the International Olympic Committee to welcome an emerging power to the front ranks of the world community.

International economic authorities agree that China is destined to continue growing at a double-digit pace. The International Monetary Fund predicts that China's expected GDP growth will be approximately ten percent, even though its export boom will ease slightly in 2008.

The World Bank was more optimistic, predicting 10.8% economic growth for China in 2008 despite economic setbacks in the U.S. caused by the subprime mortgage crisis and the surge in oil prices. The Chinese were already bracing themselves for the impact of a major economic slowdown in the United States. During 2007 almost 20 percent of China's exports went to the U.S. But, given a U.S. recession, how will China's economy hold up?

GROWING WHILE AMERICA SLOWS

Despite the enormous importance of the American consumer market, most experts we have surveyed believe that the Chinese economy will continue growing at an enviable rate even though the American economy went into reverse. The European Union is now China's biggest export market. Exports to Asia have also become an important driver for the continued expansion of the Chinese economic engine. And the Asian market has been growing steadily over the past five years.

As China's middle class and wealthy classes continue to expand exponentially, consumer demand within China itself has become an important factor in Chinese Economic Growth. Internal retail consumption is projected to continue expanding. That's partly because of the amazing number of new millionaires in the once rigidly communist nation.

More than 300,000 Chinese now have a net worth over $1 million, excluding their property, according to a study by what was Merrill Lynch. Mainland China's millionaires control approximately $530 billion in assets, according to the Boston Consulting Group. In a history-making role reversal, China contributed more to world economic growth in 2008 than the United States.

Even the best projections for U.S. economic performance in 2008 had forecast only anemic growth. The IMF's World Economic Outlook projects 1.9 percent growth for the American economy. In a recent report, the IMF credits China, India and Russia with contributing more than one half of global economic growth over the past year.

But, as the U.S. economic engine falters, China is still struggling with the opposite problem, the danger of overheating. In recent remarks, Chinese Premier Wen Jiabao warned that China needs to prevent economic growth from slipping out of control. Increasingly, Beijing's leaders are walking a fine line between rapid economic expansion and runaway growth.

Chinese authorities are constantly challenged by the problem of managing excess liquidity. With approximately $1.5 trillion worth of foreign currency reserves, the nation holds a comfortable cushion against international economic setbacks. But too much money in circulation creates an ongoing risk of runaway inflation and bubbles in real estate and stock prices.

That's why Beijing has repeatedly raised reserve ratios for the nation's banks, forcing them to freeze increasing percentages of their cash reserves rather than making new loans for factories and housing that might contribute to the creation of an economic bubble.

Too Much Cash

Beijing faces a difficult problem as American and Chinese economic performance continues to move in different directions. China's central bank has been unable to raise interest rates freely because of the drop in U.S. interest rates. Speculators who can find a way around China's tight currency controls profit by borrowing cheap U.S. dollars and investing them in China's higher interest rate and growth environment, contributing to the currency bubble. While interest rates move in opposite directions, foreign money continues to pour into China, contributing to a current account surplus that reached 12 percent of GDP during 2007.

You may have heard that America's trade deficit with China is easing. Our trade deficit is indeed growing more slowly but it is still growing. China predicts that its surplus with the U.S. will continue to grow at a 20 percent rate next year, bringing in an unprecedented $308.4 billion.

Allowing the value of the yuan to increase would help Beijing control its swelling liquidity bubble, but that's the one option that China has resolutely avoided for fear of choking off demand for exports.

Authorities in Beijing are scrambling to make decisions that will allow them to stay in control of the economy while maintaining maximum growth.

Watching these increasingly rapid-fire decisions helps guide our investment choices as we seek to profit from China's continuing high-speed growth.

INVESTING AMONG THE WORLD'S COMPANIES

Much has been said and written about the danger of a stock market bubble in China. The Shanghai's stock market is up five-fold since 2006, and many of the companies listed there have exceptionally high P/E ratios. But investors who take an interest in China must constantly remind themselves that reports about the over-valuation of stocks on the Shanghai and Shenzhen exchanges have little relation to shares listed in Hong Kong and New York. Stocks listed on China's internal markets are called A shares, and they are not directly accessible to most foreign investors. That's just as well.

It is true that China's A shares have extravagant price-earnings ratios, estimated by Goldman Sachs to be on average 60 times 2006 earnings. That compares to a ratio of 22 times earnings for Hong Kong stocks and an estimated ratio of 16 times earnings for the S&P 500. Despite China's exponential growth curve, such a high valuation for A shares is not justifiable. Chinese regulatory authorities are understandably nervous about the potential for a market crash.

But keep in mind that shares of a company like PetroChina (PTR) have a much different valuation on China's internal markets compared to their listings in Hong Kong and New York. Because of the regulatory barriers preventing Chinese investors from buying shares abroad there is no effective arbitrage equalizing the valuations of shares in any given company on different stock exchanges. That's why PetroChina may be wildly overvalued by eager retail investors in Shanghai, while the company carries a much more reasonable P/E ratio in New York and Hong Kong.

The obvious solution is to let some of the steam out of China's internal markets and discharge some excess liquidity by allowing Chinese investors to send their money to Hong Kong or New York. That's exactly what China's regulatory authorities proposed in the fall of 2007 with a scheme that came to be known as the "through-train", a plan which proposed that Chinese investment money would be allowed to flow directly into the Hong Kong Stock Exchange.

The idea generated so much excitement that shares in China-based companies on the Hong Kong exchange, so-called Red Chips, began to rise rapidly in anticipation of a flow of mainland investment. Chinese authorities panicked and began issuing contradictory statements about the through-train scheme, eventually putting it on hold. Evidently they were concerned that the values of stocks on Chinese markets might collapse if arbitrage on offshore markets was permitted.

Even though the through-train has technically been derailed, money continues to flow across the border from Shenzhen into Hong Kong as Chinese investors look for safer havens for their money. Despite official disapproval of cross-border investments, the practice is tacitly ignored by the government, creating a kind of underground market for Chinese stocks abroad.

Chinese companies are still priced much more conservatively on New York-based stock exchanges than they are in China, but that doesn't mean they haven't exploded in value. A number of stocks in the China Stock Market Digest model portfolio have increased in value well in excess of 100% over the past year. As some of those companies reached the top of our valuation range, we were able to take substantial profits. In some cases, due to high volatility among Chinese ADRs, we were able to sell some companies at their peak and repurchase them after their valuation fell precipitously, reaping a second harvest of profit from these stocks.

Although the China Stock Digest favors large cap, value investments in China, volatility is a fact of life among these issues, and we try to use price movements to the advantage of our subscribers. It's important to keep an eye on fundamentals like P/E ratios, profit margins, price-to-book and price-to-sales ratios during periods of high volatility. That volatility is often sparked by disruptions among components of the S&P 500. We look for value, and real value doesn't change during irrational market movements.

SCARE STORIES AND TEMPTATIONS

It's important not to be seduced or frightened by mass media reports on Chinese stocks. Here's one example: In the closing months of 2007, a number of major Chinese corporations, which had been traded in New York and Hong Kong, were also listed on the Shanghai Stock Exchange. The IPOs of these so-called "national champion" companies, major firms like China Life (LFC), PetroChina (PTR) and Industrial and Commercial Bank of China (ICBC), sparked immense investor excitement within China. The Shanghai IPOs were hugely oversubscribed, in some cases to the tune of half a trillion dollars in subscriptions. When the companies hit the market, share prices in Shanghai soared to unprecedented highs although offshore prices were largely unaffected.

The intent of the Chinese government in listing these companies on internal markets was to soak up excess liquidity and to give Chinese investors a stake in stable, large cap national firms, a move which might help cool the speculative fever sweeping mainland exchanges. But the listings had an unexpected side effect. Which was Excess and unwanted publicity.

With the huge Shanghai IPOs and a blockbuster quarterly report from China Life, China suddenly passed the United States as the country with the greatest number of corporations in the top ten lists of the world's larlists companies. Measured by market cap, the world-beating China corporations are China Life, PetroChina, Industrial and Commercial Bank of China and China Petroleum and Chemical Corp. (SINOPEC). The only three U.S. companies remaining in the top ten were Exxon Mobil, General Electric and Microsoft. Rounding out the list is Royal Dutch Shell, based in Holland, and Gazprom of Russia.

Critics are quick to point out that only two of the top ranked companies, PetroChina and Sinopec, ranked among the world's top fifty companies by revenue. The chorus of criticism grew even louder when PetroChina staged its trading debut in Shanghai and instantly became the world's largest company with an unheard-of market cap of more than $1 trillion. Instantly the doomsayers declared an Internet-style bubble in the making. But it's not that simple.

Valuations of China's top five companies were exaggerated by the premium prices paid in Shanghai, a price not reflected elsewhere in the world. More important, the Shanghai IPO of PetroChina reflected less than 2% of the company's shares. Most shares in national corporations are held by the government, about 86% in PetroChina's case, and they will probably never be traded because the government has no intention of giving up control. If shares are not tradable, should they be counted as having value, or are they just markers, staking out government power?

Finally, the incredible growth of Chinese firms including PetroChina quite correctly put a premium on the valuations of these firms. Critics said PetroChina was overvalued by 50%. But the company is one of the world's great discoverers and acquirers of new oil sources. That has real value.

China Mobile (CHL) also took its place among the world's top five. The company is growing exponentially, adding an incredible five to six million new subscribers every month. That is surely worth a premium. Other major carriers like China Netcom (CN) are sharing in the Internet boom. It is obvious from the chart below that China will soon surpass the U.S. in the total number of people online.

There is no doubt that China's established corporate giants will continue to grow and recover from market losses caused by ongoing volatility in the United States. As these companies return to their peak value, we are looking for new values in several booming sectors. Beyond the major wireless and landline telephone companies, we see value among some but not all of China's twenty U.S.-listed Internet corporations.

China has also become a world leader in the production of solar cells and materials. There are nineteen listed companies in this field and some have already registered triple digit market gains.

As China's environment becomes more polluted, solar energy companies and pollution fighting firms will become more valuable. The Chinese government has become an active participant, giving subsidies to companies that help fight pollution and cracking down on firms that have ignored laws against contaminating the air and water.

China is also staking out its place among pharmaceutical, biotechnology and medical devices makers. Many Chinese firms are valued far below their U.S. counterparts. They're poised to exploit a huge market as Chinese health care and economic policies are modified to support the sector.

Underlying all of our China investment strategy is the fact that we have access to the biggest new market in the world. Many westerners still think of China as a communist backwater, but the Olympics will serve as a reminder that it most certainly is not.

China has become America's biggest competitor. Whether or not it surpasses the U.S. economy, it is currently the biggest growth story in the world.

Clearly, China is the place to diversify a prudently chosen portion of any investor's international investment assets.