Originally from our sister publication, Advisor.ca.
Nearly two centuries ago, China was the largest economy in the world, accounting for a third of global output. Today, the world’s oldest civilization, and the fastest growing economy, seems determined to regain its lost glory and assert its economic supremacy on world stage.
It is the most incredible growth story that the world has ever experienced, said Princeton University economist Burton Malkiel, speaking at the annual Investment Management Consultants Association (IMCA) 2012, in National Harbor, Maryland.
“Nowhere in history have we seen a county grow this fast,” he said. “[However,] the question most people are asking is if it is going to continue.”
Malkiel says it will continue to grow and for several reasons, the most important of which is the polarized nature of its growth.
“While the eastern part of China is very well developed, the centre and the west of the country are essentially undeveloped [where] there is a lot of unrest,” he said. “Part of the strategy for the [ruling] party is ‘we want to stay in the power and we are not going to do that unless we start the growth in the [poorer parts] of the country’ where there are probably 500 million unemployed or underemployed Chinese who would like to experience the riches produced in the east.”
Unlike Europe, Japan and the U.S., China has a very strong balance sheet, he argued. “They have $3.3 trillion plus of reserves, a 17% debt to GDP ratio, versus about 100% for the U.S., about 150% for Greece and about 200% for Japan.”
And unlike the U.S. where the savings rate has dipped to zero in recent years, China boasts a savings rate of 30% to 40%, while consumption, which is 70% of the GDP in the U.S., is only 33% in China.
“It’s not like the Chinese don’t like to consume; consumption in China is growing very rapidly and will continue to grow in the years ahead.”
Malkiel says China also has an edge in other areas such as monetary policy and their banks are in far better shape than those of Europe and the U.S.
“They have fiscal policy flexibility which we don’t have because we’re so overextended in the U.S.,” he said. “If there is a problem again, the Chinese have the flexibility to [introduce] another stimulus package whereas the U.S. and Europe are badly constrained.”
What makes Malkiel so convinced China is going to grow is that it has a culture that reveres education, its people are hardworking and entrepreneurial, they have a gambling instinct and their government lets that flourish.
Investing in China, however, is very complicated. There’s an alphabet soup of shares. There are so-called ‘A’ shares that trade in Shanghai and Shenzhen. These shares are largely unavailable to non-Chinese investors. But lots of companies are registered in Hong Kong and offer what’s called ‘H’ shares, which are available for international investors. Then there are stocks of those Chinese companies that are listed on the New York Stock Exchange, called ‘N’ shares and are available to international investors.
Why invest in China
Malkiel’s first consideration is the rapid economic growth in China which he says will continue. He also contends investors are underweight in Chinese equities, not to mention Chinese stocks took a severe beating in 2011.
“Chinese stocks are available at P/E multiples just about 10 or 11; they are really at international standards or below and because they grow so fast, the P/E growth ratios are extremely attractive.”
The currency play is no small factors either. “[Investors] make their money in Chinese yuan [which] is severely undervalued in currency markets.”
That it has been lumped with emerging markets is also why investors remain underexposed to China. “If you go to Shanghai or Beijing, they don’t look like emerging markets, but the IMF determines you are if your per capita income is low and because there are hundreds of millions of [Chinese] living below the poverty line.”
Despite its growth, China remains a small portion of the MSCI EM Index and the MSCI All Country World Index. Index investors, therefore, only get 2% of China.
“You ought to have at least 9% of your portfolio in China because China’s GDP is officially 9% of the world’s GDP and will undoubtedly be larger than that of the U.S. by the end of this decade.”
Further, as the fastest growing economy in the world, China was responsible for 30% to 40% of world growth in 2010-2011. Add some currency appreciation to the mix and the case for China become even stronger.
Three investment strategies
Malkiel offered three investment strategies to benefit from China’s growth story:
Pure indexing
For at least the core of the portfolio, Malkiel says indexing makes sense as it outperforms 80% to 90% of actively managed China funds. “When you go active, you’re much more likely to get an underperforming manager than an outperforming manager.”
The FTSE/Xinhua (FXI), the MSCI and all other indices are badly flawed, he added. “For one thing, the MSCI and the FXI don’t include NY listings so a company like Baidu, which is the Chinese Google, is not even included in those indices,” he said. “Also the indices tend to be much less diversified.”
Ninety five percent of the FXI, for instance, is concentrated in three industries: banking; oil; and telecom. It has zero exposure to the consumer goods and technology, sectors in China that Malkiel says are going to grow the fastest.
Hedged strategy
A strategy that takes advantage of the greater volatility of Chinese stocks. “China is extremely volatile; the ups and downs are fierce. We calculate the implicit volatility of the Chinese market in the same way we calculate the CBOE Volatility Index, or VIX [in the US].”
In the case of China, it is calculated for the FXI and the Hang Seng Index and is called the CHIX, which is the implied volatility of Chinese stocks.
“We find that Chinese stocks have been twice as volatile as the U.S. stocks. What that means is that option premiums on the Chinese indices are very large and [by applying] the hedge strategy we take advantage of that volatility by writing options.”
A simple strategy of buying the index and writing a call option against it should produce “index like returns or a bit better with about two-thirds the volatility,” he says.
“By selling the options you provide the insurance for the investors and that’s why the strategy has been enormously successful.”
Mixed strategy
This involves direct investment in ‘H’ and ‘N’ shares and indirect investment in multinational companies that benefit from growth in China.
Mixed strategy takes advantage of growth in China without owning Chinese stocks. “[It involves] some direct ownership of Chinese stocks and some indirect investment in companies that benefit from China, and can be done entirely indirectly,” said Malkiel. “The idea is to buy multinational companies with better transparency, better accounting and less corruption.”
A portfolio made up of these companies that benefit from China’s demand for materials, industrial goods, consumer goods and luxury goods includes such international names as Coca-Cola, Pepsi, McDonald’s, Louis Vuitton, KFC, FedEx and Nike.