A quarter-century ago, Deng Xiaoping, successor to Mao Zedong, started introducing market reforms and decentralized decision-making in China. The idea was gradually to free the economy while keeping a tight, but loosening, rein on political freedom. It’s not the way most Americans would have gone about it, and China is certainly not a free country in the ideal of the Western Enlightenment, but the evolution is largely working.
Measured by what economists call “purchasing power parity” (that is, after an adjustment for what your currency can actually buy), China’s economy is now the second largest in the world, after the United States. America produced about $11 trillion of goods and services last year, or nearly $40,000 of gross domestic product per person. China’s GDP is about $6 trillion, or $5,000 per person. But China’s economy is growing much faster — about 9 percent annually, compared with an estimate of 4 to 5 percent for the United States next year and (with luck) about half that for Europe.
This isn’t a horse race or a zero-sum game. The United States will benefit from China’s growth as a nation of 1.3 billion gains the wealth to buy what we produce. My focus today, however, is on investors. How can you ignore a country that already has an economy that’s half as big as America’s and, within a generation, will be just as big?
You can’t. But investing in China is not easy.
On a recent trip to California, I sat down with Richard Gao, a native of Guangzhou, China, who works for Matthews International Capital Management. Matthews is based on Montgomery Street, in the heart of the San Francisco business district, but its analysts and portfolio managers, like Gao, travel in Asia — the focus of the firm’s seven mutual funds — for about half the year.
Matthews likes to take long-term positions in stocks, and the thousands of miles’ distance provide a broader, deeper perspective. “Sometimes we have a better idea of where Korea is headed than folks in Korea,” says a Matthews researcher.
With Mark Headley and Paul Matthews, Gao has been managing the Matthews China Fund (MCHFX) for the past five years. The record is impressive. From the start of 1999 through the end of 2003, the fund returned 27 percent annually, on average. That compares with a return of roughly zero for the U.S. benchmark, the Standard & Poor’s 500-stock index. Last year the fund returned 65 percent, which was 26 percentage points better than its own East Asia regional benchmark and 37 points better than the S&P. Through Wednesday, the fund was already up 7 percent in 2004.
Morningstar gives Matthews China five stars, its highest rating, but, remarkably, the fund has only $88 million in assets. It’s evidence of the insularity of U.S. investors that a portfolio that has boosted its shareholders’ assets by 169 percent since the start of 1999 is so small. Economists call this “domestic bias” and it’s costing Americans, as well as other non-Chinese, a lot of money.
On the other hand, the Chinese haven’t made it easy to invest in their businesses. Gao explained to me that there are four kinds of mainland China securities: those listed on the Hong Kong exchange, called “H” shares and “Red Chips”; those listed on Chinese exchanges, called “A” shares, which in general can be owned only by Chinese citizens and trade in the local currency, the yuan; Chinese-listed stocks, called “B” shares, which trade on the Shanghai and Shenzhen exchanges and can be owned by foreigners; and, finally, the few Chinese stocks that are listed, in the form of American Depositary Receipts (ADRs) or as direct securities, on U.S. exchanges.
An example in this last category is China Life Insurance (LFC), the biggest initial public offering on U.S. markets last year, raising $3.5 billion. China Life, which by the way is not among the Matthews fund’s holdings, gives an indication of China’s size and potential. China Life has 44 million life insurance policies in force. By comparison, MetLife Inc. (MET), the largest in the United States, insures 9 million American lives.
Coming later this year is an even larger IPO from China: Chinese Construction Bank, which is expected to raise $5 billion. But, as Gao points out, the state “will continue to own 70 percent to 75 percent of the company.” That’s one of the problems with investing in China — the government has the power, through its extensive shareholdings, to influence the way a company does business. Also, the government could dump its shares on the market, causing a stock to collapse.
But lately, says Gao, the Chinese government has acted responsibly, understanding that what’s good for business is good for the economy and good for the government.
Matthews China has 63 percent of its assets invested in Red Chips and H shares, 6 percent in B shares, and 27 percent in what are called “China Play” stocks, Hong Kong companies that do most of their business on the mainland. The Hong Kong exchange insists on higher-quality companies and on audits by international accounting firms. Still, A shares, says Gao, “are becoming more and more interesting, but the market is still dominated by retail investors, rumors and poor corporate governance.”
The big news for investors in all sorts of Chinese companies is that just two weeks ago the Chinese State Council issued a blueprint for a major overhaul. Chinese insurance companies, which have been severely restricted in the amount of stocks they can buy, will be able to expand their equity investments, bringing institutional stability (and a lot more demand) into the market; more companies will be able to issue stocks to raise money; and the government will revive a plan to sell its holdings in large companies — but slowly, so it doesn’t drive down prices.
But don’t try this at home. The Chinese stock markets are very tricky and it’s easy to get burned. Yes, you can consider owning ADRs and even a few of the larger Hong Kong-listed stocks, but the best strategy for most small investors is to stick to mutual funds.
China is huge but that’s nothing new. Today’s China story, in Gao’s words, is simple. “The driving force behind growth is the unprecedented economic reform program,” he says. “Even 10 years ago, most of the production came from state-owned industries. Now, 80 percent comes from private or semiprivate companies.”
China’s accession to the World Trade Organization in 2002 was the catalyst, and while neighbors worried about a giant sucking sound taking their own manufacturing business away, the opposite has occurred. As China has thrived, so have Korea (whose exports to China just surpassed those of the United States), Taiwan (which sends one-third of its exports to China), Indonesia, Thailand, and Japan. From other East Asian nations, China is buying raw materials, steel, and consumer goods.
In part because of this prosperity emanating from China, Matthews launched a new Asia Pacific fund (MPACX) last November. As Headley points out, the region “encompasses 47 percent of the world’s population, 27 percent of the world’s GDP and 19 percent of the world’s market capitalization” with 3,000 listed companies. The United States, with about 8,000 companies listed on the three major exchanges, accounts for a little over 50 percent of the world’s market cap, or value according to investors. But that’s going to change, and investors are foolish to ignore one of the greatest explosions in economic growth that the world has ever seen.
Gao cites one example: automobiles. China has just 3 million cars — about one for every 500 people. Last year, a company called Denway Motors, a joint venture between a Chinese group and Japan’s Honda, built 114,000 Honda Accords and Odysseys for the domestic Chinese market. This year, it will build 240,000 cars. The waiting list is six months. Yes, more auto imports will enter China, but they still won’t be able to keep up with demand. Denway, a Red Chip, was Matthews China’s top holding at the end of 2003.
Of the 45 stock mutual funds with five-year records listed by Morningstar in the “Pacific/Asia ex-Japan” category, Matthews China ranks No. 1, followed by Matthews Asian Growth & Income (MACSX) and Matthews Korea (MAKOX).
But Matthews doesn’t have a monopoly on well-managed China portfolios. Dreyfus Premier Greater China (DPCTX) and Columbia Newport Greater China (LNGZX) have returned more than 20 percent annually, on average, for the past five years. Other good choices are Guinness Atkinson China & Hong Kong (ICHKX) and U.S. Global Investors China (USCOX). What’s amazing about all these funds is how small they are.
Headley, one of the co-managers of Matthews China, laments the myopia of Western investors. “There really are three investable areas in the world: the United States, Europe and Asia. And if Asia isn’t even there, I don’t think that’s a good decision for the long run.”
Three warnings: Be prepared to hold for the long term, recognizing that the ride could be very rough. Own diversified portfolios of Chinese stocks because it’s hard to pick winners and losers. And recognize that Chinese stock funds tend to charge hefty expense ratios, so shop around.