Explosive Profits In The World’s Fastest-Growing Economy: China Continues Its Transition From Communism To Capitalism ~ by Joseph Lau

Explosive Profits In The World’s Fastest-Growing Economy

China Continues Its Transition From Communism To Capitalism

By Joseph Lau

This article is from the best of International Living - Subscribe To International Living Magazine ~ Get The Facts ~

(Editor’s Note: To learn how members of The Sovereign Society can profit from the transition of the world’s most populous country from communism to capitalism, Executive Director Erika Nolan recently visited Hong Kong, China’s gateway to the West. While there, she met with the principals of the Tai Fook Securities Group, a major Hong Kong financial services company. Backed by the principal shareholder in Hong Kong’s largest property development company, with a family fortune exceeding US$2 billion, Tai Fook has an immense degree of autonomy and clout in Hong Kong.

Joseph Lau is Tai Fook’s Director and Head of Investment Management.)

When former Communist Party leader Deng Xiaoping announced in the 1980s, “getting rich is glorious,” China’s 1.5 billion people took him at his word. Twenty years later, China has the world’s fastest growing economy—a truly amazing accomplishment for such a huge country. China remains a developing country—albeit a huge one. With economic growth exceeding 8% annually, year after year, well-managed companies will reap huge profits as China’s 1.5 billion increasingly affluent consumers exercise their collective economic clout to purchase enormous quantities of every conceivable consumer product. Companies that produce the infrastructure necessary to support this lifestyle will prosper.

From chemicals to electricity, cement to milk, hundreds of thousands of Chinese companies are now competing to tap this torrent of money.

But which companies will be the most profitable? Finding diamonds in the rough is never easy, and requires diligent research, including interviews with top managers, hands-on financial analysis and personal visits.

This kind of intensive analysis, often accompanied by frank criticism, is a very new phenomenon in China, a society that values consensus building and disdains open disagreement. But in China, such analysis is essential to identify well-managed, entrepreneurially driven companies, and avoid (among other businesses) former state-run relics operated by former members of the Chinese Communist party, or worse, by the party itself. Our firm has made this effort, and in a moment I’ll describe five companies that we believe will provide extremely lucrative returns for investors in the future. But first, let me tell you why China remains the world’s number one destination for investment capital—and why the naysayers who predict a Chinese economic collapse are wrong.

Five Reasons China Shares Will Soar In The Years To Come
1. China is now the #1 destination for foreign investors—far surpassing the United States.

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Foreign direct investment in China is expected to surpass US$70 billion in 2004. Yet, in an effort to restrain uncontrolled growth, the Chinese government is restricting the types of investments that can be made there. These restrictions will redirect investments into Chinese shares—particularly those traded in Hong Kong, where there are no restrictions on share ownership as exist in China itself.

2. Increased prospects for a floating Chinese currency are fueling capital inflows. While the Hong Kong dollar and the Chinese renminbi are tied to the U.S. dollar, there is widespread expectation that Chinese authorities will eventually permit the renminbi to float in world currency markets. Due to the immense U.S. balance of trade deficit with China, a free-floating renminbi is likely to appreciate sharply against the U.S. dollar. This has led to multi-billion-dollar capital inflows into China and Chinese shares.

3. Asian markets are beginning to recover after a prolonged period of asset deflation. Hong Kong is one example of asset “reflation,” which we believe will be the key investment theme for Asian markets for the next few years.

4. Fears of economic austerity measures in China are overblown. While the efforts taken by authorities in China to reign in uncontrolled economic growth have received a great deal of negative publicity, they have produced desirable effects. Most important are the slowing investments in fixed assets such as factories and major infrastructure projects. We believe that the Chinese economy has passed its most critical moment, and thus, we think it will continue to grow at a high single digit rate every year for the next few years, perhaps until the 2008 Beijing Olympics.

5. Global markets have over-reacted to the expectation of higher U.S. interest rates. We see evidence of this in the fact that prices for bonds and interest-rate-sensitive shares are now rising after a sharp sell-off in early 2004. In addition, continued softness in the U.S. economy suggests that this round of interest rate increases will be gradual.

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Further, interest rates are rising from a very low base—the lowest in nearly 50 years.

Buy Now, While The Market Is Recovering

Based on this reasoning, we have an overall buy recommendation for the Hong Kong market and Chinese shares listed in Hong Kong.

Why Hong Kong, and not China itself? The reason is that the Chinese government currently permits only large institutional investors—not individuals—to invest directly in Chinese securities. But foreign investors can buy and sell Chinese shares listed in Hong Kong without restriction. This restriction on direct share ownership of Chinese shares, combined with the additional restrictions now being imposed on new foreign investments in China, places the large number of Chinese securities listed in Hong Kong—”H-shares”—in an ideal position to rise in value.

As the chart indicates, after a stellar performance in 2003, share prices of Chinese companies listed in Hong Kong fell sharply in the early months of 2004. While they have regained some ground in recent weeks, we believe that there is an excellent chance that the market will test its all-time highs in the first half of 2005 at the latest. We therefore look at the current period of market weakness as a buying opportunity.

These H-shares Have Our Highest Recommendation

Better living through chemistry. In the recent market sell-off triggered by austerity measures, the chemical sector fell with the broader market. However, the austerity measures were designed to limit investment, not consumption. And consumption of refined chemical products such as resins and synthetic rubber continues to increase at a rapid pace. Supply-demand dynamics favor a sharp price increase in this market segment until at least 2006. With a forecast price-to-earnings multiple of less than seven times (dependent on 2004 earnings), we recommend Beijing Yanhua (0325.HK) as a safe bet in this sector.

Put a spark in your portfolio. Power shortages are a regular occurrence in China and the booming economy will only make matters worse. In addition, soaring energy prices—most importantly, in coal—are forcing inefficient power producers out of business. The supply-demand imbalance will eventually be resolved, but electricity will continue to be a growth sector in China for years to come. Our top pick in this industry is Huaneng (902.HK), one of China’s largest and most efficient power producers. While many analysts think it is fully valued, we disagree and recommend accumulating it on any market weakness. Huaneng’s 4% annual yield is a significant downside cushion. Huaneng is also traded in the U.S. as an American Depository Receipt (ADR)—symbol HNP.

A double play on renminbi appreciation. If China eventually revalues the renminbi, as we anticipate, companies with expenses and debts denominated in foreign currencies, but with revenue in renminbi, will benefit from both sides of the revaluation. One industry that fits this category in China is aviation, since the industry's #1 cost is fuel oil, mostly imported from abroad and denominated in U.S. dollars. Aviation is also a growth industry in China, with a low "penetration rate;" i.e., the vast majority of Chinese citizens have never flown in a plane. In this category, my colleague Matt Hu highly recommends China Eastern Airlines (670.HK), which he believes that it will have positive earnings surprise to investors in 2004.

Milk: It does an investor good. In China, milk has historically been considered a luxury item. Now, increasingly affluent Chinese consumers are drinking much greater quantities of milk. But per capita milk consumption remains far below that of South Korea, Hong Kong, Singapore and Japan, and even further below that of most western countries. We forecast an average annual compound growth rate of 40% for liquid milk consumption for the next few years. In this sector, my colleague Hu Meng recommends Mengniu Dairy (2319.HK). While Mengniu isn’t China’s largest dairy, it is a market leader, and in his view better managed than the number one dairy, Yili. Crucially, Mengniu started as a private company; Yili as a state-owned enterprise. Yili’s bureaucratic management structure has led to management rivalries, creating an opportunity for Mengniu to take over some of its market share.

A safer way to invest in China. There are significant risks associated with investing in individual shares in a developing country such as China. While we believe the prices of all of these shares will be significantly higher in the years to come, price volatility is almost guaranteed. A less aggressive approach than investing in individual shares is to buy the Hong Kong Market Tracker Fund (2800.HK), which tracks Hong Kong’s most broad-based share index, the Hang Seng Index. As there are objective criteria for listed companies to qualify for this index, this fund is an efficient way to gain access to China’s economic growth.

Another option is to buy into the fund, C T China Investment Fund, managed by Tai Fook Century Asset Management. This firm is a joint venture between Tai Fook Asset Management and Century Holding from China. (Editor’s Note: Due to potentially unfavorable tax consequences, U.S. persons considering offshore funds should consult with an experienced tax advisor prior to making an investment. However, these consequences do not extend to individual foreign shares.)

Whatever investments you choose to participate in the Chinese “economic miracle,” we believe you will be richly rewarded in the years to come.

For More Information

To learn more about investing in China, or about the shares recommended in this article, contact:
Joseph Lau, Director and Head of Investment Management, Tai Fook Asset Management Limited 25/F., New World Tower, 16-18 Queen’s Road Central, Hong Kong. Tel: +(852) 280-12-475 Fax: +(852) 252-59-265. E-mail: joseph@taifook.com.

Joseph Lau holds a masters degree in Economics and is a Chartered Financial Analyst. After working as a fund manager in Hong Kong for more than ten years at companies such as Schroders and Jardine Fleming, in 2000, Joseph joined Tai Fook. His primary focus is on Chinese shares listed in Hong Kong. Joseph travels extensively in China, and works closely with experienced China fund managers to look for investment opportunities there.

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