A China Strategy Is More Important Than Ever 01-04-07

Inside China Dispatch: 01-04-07

Robert Hsu, January 04, 2007

Dear Fellow Investor,

Happy New Year! The Chinese New Year isn't until February, but since we here in the U.S. are celebrating the start of a new year, let me wish you the traditional Chinese greeting of Gung shi fa tsai, which translates to "Congratulations and be prosperous."

Prosperity is what we enjoyed in 2006, and as a reader of Inside China Dispatch, I hope you have a strong sense for the kinds of wealth-building opportunities made possible by China's historic growth. Just in the last quarter of the year, the stocks I recommend in my China Strategy service were up an average of about 20%! That more than tripled the S&P 500. (Click here to learn how you can join today and get immediate access to all of my current recommendations.)

I expect more great results here in 2007. Why? Because the long-term trends driving our stocks are so powerful that there is no stopping them. China is hot right now, but it's not like the 1990s when Internet stocks were flying based purely on hype. In fact, it's quite the opposite. This is one case where the underlying fundamentals are probably better than any hype you might hear.

Those of you who have been with me a while have heard me say it before, but it bears repeating as we begin a new year: China is the mother of all investment themes right now. No matter how you slice it—population size, demographic trends, economic reforms, corporate growth, etc.—China's economic miracle is real.

Last week, we looked back at the trends driving the China Miracle and our gains in 2006. This week, I thought we'd peak into the future and some of the most significant trends I expect us to profit from in 2007.

A China Strategy Is More Important Than Ever

Before jumping into some specific thoughts for 2007, let me share my brief analysis of what I expect from the U.S. economy and stock market and how they affect our strategy. Last year, the economy behaved exactly as I expected it to, with growth slowing towards the end of the year. For 2007, I expect a continuation of that trend, with growth slowing to probably 2% or lower—enough to barely keep us out of a recession.

However, the good news is that I expect U.S. corporate earnings—the most important determinant of stock prices—to hold up better than the economy. In part, we have China to thank for this. Corporate earnings doubled during the past five years as a result of companies both outsourcing to and expanding their businesses in foreign markets, and China certainly tops the list.

With slower growth in the U.S., I see outsourcing and foreign expansion accelerating in 2007, helping U.S. companies to once again earn record profits. Those profits will be critical in supporting the stock market during a period of weaker growth.

Add it all up, and I look for the S&P 500 to have a decent year in 2007, probably gaining around its historical average of 7% to 9%.

Not bad, but I want more than that, and I'm sure you do, too. Now, more than ever, investors looking to build their wealth must look outside of the U.S. for real, sustainable growth. Topping the list is China, which continues to grow almost 10% a year. As more and more investors realize this, I expect the stocks like the ones I recommend in China Strategy to be among the biggest winners. (Click here to learn more.)

Now, let's talk about a couple of specific trends I expect to drive those winners:

The Consumer Spending Boom

We've talked about the coming consumer spending explosion before, but I believe it is the single most exciting opportunity in China right now. As we begin 2007, China is just now allowing international banks to do business there, and I expect this to result in an unprecedented boom in spending.

You've probably heard that financial giant Citigroup led a consortium that just acquired 85% of the Guangdong Development Bank (GDB). Citi not only expects to have significant influence on how the bank is run, it also gets access to GDB's 500 bank branches.

One thing U.S. banks are extremely good at is marketing credit cards, and I look for consumer lending to become one of the biggest growth sectors in China. The current credit card penetration rate among Chinese adults is less than 2%, while the savings rate there is 35%. By comparison, credit card penetration in the U.S. is more than 100% and the savings rate is under 2%.

See the potential? I expect the number of Chinese with credit cards will double this year and continue to grow rapidly for a long time.

Chinese banks are already trying to preempt the foreign banks by issuing credit cards en masse, especially to the more affluent middle-class Chuppies. Our analysts in China are reporting to me that it's far easier to get credit cards today than it was just a few months ago.

Our consumer trend analyst, Frances, is a great example. She's had one credit card for a little over a year. She had to fill out more than five applications for that card, and it came with a credit limit of 10,000 yuan. In the past three months, she's received two new gold cards from different Chinese banks—without even applying for them!

Those cards came pre-approved and with higher credit limits of 20,000 and 15,000 yuan, even though she didn't have to disclose any financial information. Her total credit line went from 10,000 yuan only a few months ago to 48,000 yuan today without any increase in her personal income.

She also told me that she is tempted to buy a Louis Vuitton purse with her new credit cards, and that's a key point: I believe greater access to credit cards will unleash pent-up demand and lead to the greatest consumer explosion the world has ever seen.

How do we profit? Not with banks—at least not yet. China's banking sector is still a mess, and though it's getting better, I believe it will be some time before everything is cleaned up to the point where we want to invest in them.

The best way to profit right now is by investing in the products Chinese consumers will spend their money on, and the majority of the stocks I recommend in China Strategy fit into those categories. I'm talking about things like tourism (our online travel stock was up 51% for us in 2006), advertising (our play here shot up 97% last year), wireless communication (up 80% for us), online gaming (up 47%), healthcare (up 44%), education (up 34%) and dining out (up 25%).

I look forward to watching this spending boom unfold with you and riding the wave to big profits in 2007 and beyond. (If you'd like to get in on the profits right away, click here to join China Strategy at discounted prices and go right to our list of recommended stocks.)

China's Exploding Private Sector

Another area I'll be watching is China's private businesses, which will continue to grow rapidly in 2007 as market reforms allow the entrepreneurial spirit that has been buried under decades of Communist rule to once again flourish. And that's exactly how it should be. The Chinese people are the real drivers of their country's economic miracle.

The best privately owned and operated companies are thriving and taking market share away from the big, state-owned manufacturing companies left over from the Communist economic model. Under the old Communist system, their purpose was simply to provide employment, so they were never concerned with the bottom line. Most are bloated, inefficient and often corrupt, so it's no wonder that the percentage of the economy controlled by state-owned enterprises has fallen dramatically over the last 10 years from more than 70% to less than 40%.

Because the best private companies in China enjoy such tremendous growth, many are now big enough to be publicly traded, which is obviously great news for us as investors. In China Strategy, we already own some of the best. For example, in late 2006, we jumped on a Chinese medical device company and an education provider—and they were up 44% and 34% for us through the end of the year! There will be more to come in 2007, and I'll be watching closely for our next great opportunity.

I should warn you that a growing number of smaller Chinese companies are also getting listed, though many are doing it through less reputable ways like on the pink sheets. These companies are very risky, and I recommend you stay away from them. The best strategy is to invest in recognized and established Chinese industry leaders. This not only minimizes your risk, it's also where the best opportunities are. China's climate favors big businesses, so I'll continue to recommend stocks that are number one or two in their industries.

Until next week,

Robert Hsu
Editor, China Strategy

P.S. And speaking of industry leaders that recently went public, I'm recommending one in the brand new issue of China Strategy. This is one you want to be sure you get at the right price. Click here to join today and get immediate access to my full report, including my important buy limit.

Inside China Dispatch: 01-04-07

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