China is widely considered to be one of the most attractive and exciting long-term investment opportunities in the world. Last year, this nation of 1.3 billion people replaced Japan as the world’s second-largest economy and could surpass the US economy as soon as 2025. It already is the world’s largest exporter.
But after more than a decade of economic growth that averaged 9.9% per year and stock market returns that averaged 7.7%, there have been clouds in China’s investment outlook. Investors are asking whether China’s attempts to fight inflation by raising interest rates along with other measures will slow economic growth to a drastic degree. That could have bleak consequences not only for investments in China but also in other emerging markets and in diversified foreign-stock mutual funds.
Bottom Line/Personal asked emerging-markets investment expert Paul Goodwin why China is still a great place to invest despite the challenges it faces…
GROWING PAINS
From early November last year to late January, the Shanghai Composite Index plunged by more than 15%. It ended 2010 with an 11% loss for the year, compared with a 15% gain for the Standard & Poor’s 500 stock index.
Reason: Investor confidence was shaken as China faced rapidly rising inflation.
That inflation—a 5.4% gain in consumer prices for the 12 months ended in March—stemmed from factors such as a red-hot real estate market and the spiking cost of many commodities that China imports, such as oil, copper and iron ore. The central government raised its benchmark short-term interest rate four times in the last six months and will probably have to keep raising rates for months, which investors fear might crush economic growth.
These all are reasons for concern, but long-term investors shouldn’t panic. I think the government will be able to steer a path that avoids both runaway inflation and a plunge in economic growth. In fact, the Chinese stock market is up by about 8% this year as of mid-April despite additional pressures, such as soaring oil prices and much higher wheat prices due to a severe winter drought in China’s Northern Plains.
While there have been spectacular real estate price increases in such major cities as Beijing, Shanghai and Guangzhou, China isn’t facing a credit bubble like the one that devastated the US banking system in recent years. It avoided that kind of crisis by imposing strict mortgage lending requirements and strictly regulating the sale of derivatives—the packaged baskets of shaky mortgage loans that helped crush the US credit and real estate markets and that Warren Buffett dubbed “weapons of mass destruction.”
What’s really happening is that China is going through big growing pains as it struggles to decrease its tremendous reliance on selling exports to the rest of the world and increase its own domestic consumer spending. In the next few years, China’s economy is likely to grow by 7% to 10% a year—that’s still two to three times the rate that sluggish developed economies will likely achieve.
HOW TO INVEST
As an investor, it’s important that you have some exposure to China—which represents more than 10% of the world’s gross domestic product (GDP)—but you have to know how to invest there.
It’s difficult for foreigners to invest in China’s public companies directly because foreigners are required to have expensive, hard-to-obtain permits. Also, Chinese companies tend to have substandard accounting and financial disclosure practices. To avoid this problem, I choose investments only from among the 200 Chinese companies whose stocks trade as American Depositary Receipts (ADRs) in the US. These ADRs, which represent ownership in shares of foreign corporations that trade in US financial markets, are denominated in US dollars. They offer a measure of safety because the companies issuing the shares must meet stringent accounting, disclosure and financial statement standards approved by the Securities and Exchange Commission.
I also like US companies that have expanding operations in China.
Warning: Avoid the common mistake of investing in index funds and exchange-traded funds (ETFs) that track the broad Chinese stock market. That market can be very volatile, and I don’t want to risk losing 65% as the Shanghai Composite Index did in 2008.
My preferred approach is to focus on Chinese companies that are tapping into three trends so powerful that they are unlikely to be derailed by higher inflation or a slowdown in economic growth…
TREND 1: City living
China’s ongoing rural-to-urban shift is one of the largest human migrations in history. City populations will expand by 20 million this year. The stocks that benefit…
TREND 2: Trading up
Along with moving to cities, millions of Chinese workers are earning higher wages, joining the middle class and exercising their new consumer spending power by buying homes, automobiles and computers and traveling more. The stocks that benefit…
TREND 3: Building boom
The vast central and western regions of China still are largely underdeveloped. To balance out the vast improvements that have taken place in the big cities, China will make sure that these regions get trillions of dollars of basic infrastructure, including raw materials, power generation, roads, rail lines, airports, and water and waste systems. The stocks that benefit…
