Journey to the East

Robert Hsu, September 01, 2007

In the China Strategy Dispatch that I emailed you on July 19, I told you about my trip to Shenzhen. Shenzhen is one of the world's greatest boomtowns, going from tiny village to major metropolis in just 25 years.

The city has become one of China's financial centers. While I was in China last month, our China Investing Tour Group and I stopped in Shenzhen and visited China Merchants Securities, one of the top brokerage firms in the country.

I was excited about the visit because China Merchants Securities has an excellent reputation as one of the top research-oriented brokers in China. Although the firm started out as a state-owned enterprise, it granted senior managers substantial stakes in the company, and it's planning an IPO in Shenzhen later this year. The firm's IPO will create a liquidity event that will create seven-figure wealth (measured in U.S. dollars) for several senior managers.

A team of eight managers and representatives from China Merchants Securities treated our China Investment Tour Group to a delicious eight-course luncheon banquet. Most of the managers from the brokerage firm spoke fluent English, and many have family and friends living in North America. For instance, the head of the firm's international department, Kevin He, works in Shenzhen, but his family lives in Toronto.

The highlight of our afternoon at the firm was an investment strategy presentation from John Ho, the firm's director of research.

You may recall that I talked about John briefly in the July 19 Dispatch, but today I want to give you the full details on what John had to say during our visit.

A graduate of the University of Southern California's MBA program, John speaks perfect English and previously worked as a fund manager at Dutch insurance giant ING. Just a few years ago, it was unheard of for a fund manager at a major Western financial institution to jump ship for a Mainland Chinese company. Yet during my recent trip to China, I met two outstanding executives who did exactly that -- Joyce Hsu, who left Goldman Sachs to become the CFO of Mindray Medical (NYSE: MR), and John, who left ING for China Merchants Securities. Joyce and John are living proof that the opportunities available in China today are just that good.

John gave a presentation called "Journey to the East," which detailed his strategies for investing in China. The presentation covered the huge rally in the domestic Chinese stock market during the past two years. Over the past 13 years, the aggregate domestic stock market cap in China grew at an average rate of 140% per year as a result of increasing offerings and market appreciation.

Several factors are pushing the Chinese stock market higher, including strong corporate profits, the consistent appreciation of the yuan and high liquidity.

Let's look at that last factor -- liquidity. Right now, Mainland China is one of the most liquid countries in the world. Chinese stocks are trading at high valuations, but that's perfectly logical considering that thanks to China's high savings rate, there's currently $3 trillion in the Chinese banking system seeking higher returns. As we've talked about before, the only viable investment options for most local Chinese citizens are real estate and domestic stocks (also called A-shares).

During his presentation, John pointed out that despite the huge run-up in A-shares, China's current total stock market cap is only 63% of the country's $2.8 trillion GDP. That's significantly lower than the ratio in both the U.S. (146%) and Japan (107%).

Based on all of this evidence, John believes -- like I do -- that there's still significant upside potential for domestic Chinese stocks despite all the bubble talk we read about here in the West.

In fact, we saw evidence of the incredible momentum in the Chinese stocks recently. As markets around the world pulled back because of U.S. credit problems, Chinese stocks in Shanghai continued to rally. To find out which of our funds is benefiting from the climbing Chinese exchanges, click here to view the full article.

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But as foreign investors, other than buying shares of our fund, you and I are restricted from investing directly in China's red-hot A-shares. As a result, John laid out a strategy for investing in China's B-shares, which are dollar-denominated securities that were designed specifically for non-Chinese overseas investors.

John feels that eventually China's A- and B-share stocks will converge in value, and the current 90% premium in A-shares creates a buying opportunity for B-share stocks. I talked about this possibility in the June issue of China Strategy, and it's interesting that John feels the two classes of stock will merge.

However, as I also mentioned in the June issue, investing in the B-shares is possible, but not simple. Most investors who are interested will need to physically travel to places like Shanghai and Shenzhen to personally fill out all of the paperwork needed to set up an account. Some B-share stocks can be purchased directly from full-service brokerage firms, but these services are not widely available yet.

Since the B-share market is still too far out of reach for most China Strategy investors, I was happy to hear that John also likes H-share stocks, or Chinese companies that are listed in Hong Kong. He favors these stocks (just like I do) because of their relatively low valuations. Many of the Chinese ADRs in our China Strategy portfolio are backed by H-share stocks, so we get the same benefit by buying the ADRs in New York.

John explained that earnings growth this year for H-share companies is a healthy 28%, which is more than twice the earnings growth of the S&P 500. Yet the P/E ratio for H-share stocks is only 18, which is slightly higher than the S&P 500. The superior growth rate and comparable valuation in H-share stocks, combined with an appreciating yuan, makes Chinese companies more attractive than U.S. companies in general.

John also told us that he believes there will be an eventual convergence between H-share and A-share stocks. The creation of the QDII -- which we talked about in the June issue of China Strategy -- is the first step towards this convergence. The QDII allows Chinese institutions to create instruments that invest in Hong Kong. If John's prediction comes true and A-shares converge with H-shares, then H-shares still have a long way to go up before catching up to A-share stock valuations -- and they should take our China Strategy holdings along for the ride.

A Boost of Confidence

It was clear from his presentation that John's investment thesis for China is similar to mine. He believes that China is the world's fastest-growing economy and that investors should focus on the best growth opportunities available in the country. The Chinese stock market will continue to go up until valuations become unsustainable, and with earnings growing at nearly 30% a year, the market can go up 30% a year and not expand its P/E multiple.

After listening to John's presentation, our group developed an even greater confidence in our China Strategy portfolio. I've always been optimistic about the performance of H-shares, but John's refreshing analysis of the A-share market made me more bullish on the Mainland Chinese stock market.

Market actions over the past month have confirmed our bullish outlook on the Mainland Chinese stock market. Stocks all over the world, including H-shares in Hong Kong, sold off recently because of the subprime problems in the U.S., but Mainland Chinese stocks continued their rally. Our investment in the Morgan Stanley China A-Shares Fund is 20% higher now than it was in July when the subprime problem started.

Why have A-shares held up so well in the face of the recent credit crunch? The answer is simple -- Chinese exchanges are isolated from foreign investors. Unlike stock markets around the world with heavy exposure to U.S. and European institutional investors, the Mainland Chinese market is controlled by local money.

This isolation and the "market mania" that has seized China has caused some analysts to mistakenly label the rally as a bubble. While signs of frenzied speculation are beginning to emerge, I believe the current situation in China is far from becoming a full-blown bubble. When it comes down to it, liquidity and earnings drive stock markets, and both of these factors are working in favor of China's markets right now. I expect China's liquidity and earnings to remain strong and drive the Chinese exchanges for years to come.

And John, a highly respected research director at one of China's top brokerage firms, agrees with me.

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