Investment Opportunities

Investing in Chinese Stocks: Capture Growth and Manage Risk

Soon I’ll be publishing a new book and releasing a special report with sharply different messages.

New World, New Boom: Capture Growth Like the New Tycoons is a very blue-ocean optimistic book. It’s chock full of strategies and ideas to help investors grow wealthy with emerging and frontier markets.

The special report aimed at institutional investors, How Seven Trends Could Break China, challenges the conventional wisdom that China is an economic juggernaut and a one-way bet for investors. Its basic premise is that China’s economic and political system isn’t sustainable and will end badly.

Am I crazy bipolar or what?

Let me explain.

China’s Strategy Has Run its Course

You would be hard pressed to find someone more enthusiastic about emerging markets than I am. During the past 30 years, their progress has been remarkable, as market reforms and breakthroughs in technology and communications pulled hundreds of millions of people out of poverty.

The world filled in, and in my view, we’re just getting started.

China, in particular, is a remarkable growth story. China now exports more in one day than it did in the entire year of 1978, just before it opened up to the world. In 1990, its economy was the same size of Taiwan; now it’s more than 10 times larger.

But in my personal view, the strategy that fueled China’s success has largely run its course. More importantly, its political and economic system isn’t flexible enough to adjust to the serious challenges that confront it.

Here’s how Minxin Pei puts it in this week’s Financial Times:

“As China marks the 20th anniversary of Deng’s history-changing tour, the most ironic fact – and perhaps China’s worst-kept secret – is that pro-market economic reform in China has been dead for some time.”

So if you carry my thinking to its logical conclusion, the biggest threat to my optimistic view for robust Asian growth isn’t the euro debt crisis or America’s out of control debt and spending.

It’s China.

If this is unthinkable to you, I have a question: Did you expect unbeatable Japan to stagnate for two decades after its property and banking crisis or the sudden collapse of the Soviet Union?

Not So Fast, Though

But even if I’m right about this risk, I strongly recommend that you not go out and sell all your China stocks for a number of reasons.

First, the direction and/or pace of the seven negative trends in my report aren’t set in stone. While I’m skeptical that “moneybags communism” can endure, the government has tools at hand to kick the can down the road, and they’ll certainly try to do just that as long as possible.

Second, Chinese stock markets are usually driven by liquidity and momentum rather than fundamentals. There were many years during the 1990s when the Chinese economy was growing at 10%-plus rates and the stock markets did nothing.

iShares FTSE China 25 Index Fund (NYSE: FXI) is an ETF basket containing China’s largest 25 companies. While China’s GDP growth is consistently growing at 10%-plus pace, FXI’s performance is on a rollercoaster.

A buy and hold strategy for China has been, well, disappointing.

As 2012 markets opened, the Shanghai market is coming off a two-year period of weakness – down 37%. Therefore, many stocks, and especially the banks, are trading at attractive valuations. This is why I wrote several times in the past few months that China stocks look dirt cheap.

This doesn’t mean the market will go up, but it does make it more likely. And so far in 2012, FXI is showing an upward trend.

On the liquidity issue, some of the domino trends might boost the market in the short term. As Chinese property markets slide, investors may very well move this wall of liquidity to stock markets. After all, what other choices do they have?

The state banking system set interest rates so low that they’re negative after adjusting for inflation. No wonder the Chinese who are able are moving capital offshore.

The One Simple Step

But there are simple steps you can take to limit or hedge Chinese risk. And the most important is to put in place a 15% to 20% trailing stop when investing in FXI, or any Chinese stock for that matter.

By doing this, you can capture any momentum in the Chinese market, but you’ll also protect yourself against the risks of continued market weakness.

So keep investing in emerging markets and Chinese growth, just be careful to manage the risks.

Good Investing,

Carl Delfeld

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