Last Sunday February 18th marked the Chinese New Year and once again it's been a time of fireworks, feasting and those famous red envelopes. But the celebrations for investors started much earlier, as 2006 was an incredible year for Chinese companies. As the New Year gets started, its worth considering whether the party will last…
The great economic boom in China can be said to have stemmed from the reforms of the 1970s when the government started to open up China to foreign investment and world trade, culminating with their entry into the World Trade Organisation in 2001. From that moment, the Shanghai Stock Exchange (SSE) Composite Index proceeded to lose over half its value. 2006 however saw the index almost triple, and once again, people are questioning whether Chinese investments are in bubble territory.
To answer this we need to consider not only the current state of the economy but also the nature of markets and the psychology of bull and bear markets.
The Economy
China is one of the few places in the world where double digit growth is seen as a realistic achievement and in 2006 the Chinese economy grew by around 10 per cent. Currently, the country boasts the fourth largest economy in the world and is set to overtake Germany as the third largest by 2009. With an ever increasingly educated population of over 1.2 billion people willing to work for far less than a Western employee would find acceptable and an opening up to foreign trade and investment, it is hard to find reasons against China's continued long term growth.
Both export business and domestic demand have been fuelling this growth. Exports are one thing that need to be carefully monitored; with high debt levels and rising rates. Consumer demand in the West can only remain strong for so long.
The Market
However investors should remember that stock market performance can behave quite differently to the national economy. From 2001 to 2005 the Chinese markets saw a slump in prices, in spite of rapid economic growth.
The end of 2005 saw the turn of the SSE and it kicked off the current bull market, but will it continue? Currently, mainland China stocks are trading on a multiple of around 25, which has led to many experts suggesting that we are firmly in bubble territory. This may be the case, but it is important to remember that one of the features of a bubble is that they tend to go on for a lot longer than expected. Alan Greenspan, former Chairman of the Board of Governors of the Federal Reserve, famously warned of "irrational exuberance" in 1996, but the market continued rising strongly for another four years. We've seen the multiple up to 60 before and considering the high growth rate of the economy, a multiple of 25 does not look overly expensive.
Markets do not rise in a straight line and corrections should be expected when prices get a little bit ahead. Analysts often jump on these corrections as evidence of the end of a bull market and can be wrong. We've been in a bull market for a little over a year, which is a short time when compared to previous histories. It is the size of the increases that are causing concern.
The political situation should also be considered. It would seem as if the Chinese Government is trying to contain the market by 'talking it down'. Politicians fear a bubble and crash scenario developing, reminiscent of what was seen with the Nasdaq market. Now that China has emerged as a major player on the world platform where stability is king the Government’s attempts to calm things down are unsurprising. Some senior Beijing financial figures have warned of a potential bubble, which led to the recent sell off. However, talk can only go so far in limiting a market, and they are unlikely to change anything structurally ahead of the Olympics next year.
In the short term, we may well have entered into significant correction, as institutions seek to lock in profits after a period of sharp rises, and the froth is taken out of the market. And historically speaking the Chinese market is often weak after the New Year. However, the bull market should not necessarily be considered down and out and a correction may provide some very good buying opportunities.
Gaining exposure to China
Investors who like to spread their risk as much as possible and diversify their funds will want to look at iShares FTSE/Xinhua China 25, a recently launched Exchange Traded Fund (ETF). ETFs are very popular in the US and are rapidly gaining popularity here in the UK. As the name suggests, they act like a fund that trades on the market. The fund can be made up of anything from the FTSE 100 index (ISF) to pure exposure to the Copper price (COPA), or in the case of the iShares FTSE/Xinhua China 25 ETF, 25 Hong Kong listed companies which conduct most of their business in China (PRC). This includes the likes of China Mobile, PetroChina, ChinaLife Insurance and the Bank of China. Trading ETFs is generally a cheaper and simpler technique than investing into a fund directly and all good stockbrokers should allow you to trade in these.
Commodity fans will want to look at another ETF, COPA which tracks the price of copper. After meteoric rises in copper prices over the last few years (mostly because of huge Chinese consumption) the last six months have seen this metal lose around a quarter of its value. Such corrections are normal in the commodity market and many analysts expect the price of copper to rise throughout 2007. Signs of improved demand from China are apparent, and should continue as we move into the Chinese New Year. Recently the London Metals Exchange reported a sharp drop in stockpile levels and data showed that China imports of unwrought copper and semi-finished copper products rose 44 per cent in January over December. After a decline of over 25 per cent, copper may prove to have been a very good buy at current levels.
Those that want to try and outperform the market can take a sector-specific approach. One area to exercise caution over is the financial and banking sector. Although they generally have good earnings visibility, these sectors have some of the highest valuations in the world.
The automobile sector, although very competitive looks promising. China is now the second biggest car market in the world, however sales compared to the population size remains small, and coupled with a rapidly growing economy and high personal aspirations for car ownership, the future for the industry looks to be in full drive.
One area that is often neglected in a rapidly developing economy is environmental and green issues, and China is no different, with smog becoming a normal part of city life. As a nation’s wealth increases, concerns about environmental issues tend to come to the forefront and recent developments indicate that China is taking the issue seriously. A deal between General Electric and the Chinese Government was recently struck with a $50m promise to invest in developing green technologies.
Those that want to invest in China and like high-risk, high-reward investments should look no further than London's Alternative Investment Market (AIM). The number of smaller companies on AIM that have a China link has now grown to around 50 and make up more than three per cent of the market in terms of capitalisation. Throughout 2006, many of these became AIMs top performers. One such company to consider is London Asia Capital (LDC) a Chinese Investment Company that appears to be good value currently.
LED (LED) is a Chinese based manufacturer of LED based products including LED screens used for advertising. The company is profitable, and has a decent growth rate, which should be helped along as we head towards the Olympics next year. With a P/E of around 11, they also look cheap.
Taihua (TAIH) supplies core ingredients for the blockbuster drug Taxol, as well as selling popular Chinese herbal medicines. Again they are profitable, and are trading on a forward P/E of just over six, against a mainly loss making peer group.
Conclusion
2006 has seen the Chinese market re-emerge as a market to be in. In any fast growing market, corrections and wild swings tend to appear. Maybe the future will reward those who use the downturns to pick up investments cheaply, rather than jumping on the "end of the bull market" bandwagon.
Hoodless Brennan is a leading specialist in the small cap market and provides award-winning share dealing services including the UK’s lowest cost online trading according to Moneysupermarket.com. www.hoodlessbrennan.com
RISK WARNING NOTICE: All investments are speculative and prices may change quickly and go down as well as up. Past performance will not necessarily be repeated and is no guarantee of future success. There is an extra risk of losing money when shares are bought in some smaller companies including “penny shares”. There can be a big difference between the buying price and the selling price of these shares and if they have to be sold immediately, you may get back much less than you paid for them or in some circumstances, it may be difficult to sell at any price. It may also be difficult for you to obtain reliable information about the value of this investment or the extent of the risks to which it is exposed. Where a company has chosen to borrow money (gearing) as part of its business strategy its share price may become more volatile and subject to sudden and large falls. This investment may not be suitable for all investors, and clients should carefully consider their own personal financial circumstances before dealing in the stock market, particularly those on fixed incomes or approaching retirement age. If you have any doubts you should seek advice from your investment adviser or your broker at this firm.
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