China's powerful lure

A return to bull market conditions in Chinese shares is luring a new generation of Australian investors. Although the Chinese economy has boomed for a decade, China's fledgling stockmarket has offered highly erratic returns '” powering ahead in bursts then fading under the weight of excess speculation.

Now things may be changing. A string of dramatic reforms have been pushed through the Chinese stockmarkets that favour overseas investors. Whether the authorities actually enforce these new regulations will be crucial, but there are now at least standards and regulations where none existed previously.

Until recently Australian retail investors could only access China stocks through unlisted specialist funds. What is more, these funds did not invest in mainland China, they mostly invested in Hong Kong listed stocks or “H” shares, which acted as a proxy for Chinese companies operating in the leading financial centres of Shanghai and Shenzen.

After courting Chinese authorities for a decade, AMP received a first last year when it was granted an Australian licence to raise a $US200 million fund that could invest directly in Chinese listed shares. The AMP Capital China Growth Fund, under portfolio manager (Asian investments) Karma Wilson, listed late last year with a net asset value of 96¢ per unit; it is now trading around $1.14, representing a 20% increase for investors to date.

AMP has been among the leaders in pushing into China. It already runs an unlisted China funds which compete with locally available global funds such as the market leader Fidelity China Fund.

Source: Morningstar

Meanwhile, Investors in AMP Capital's listed China Growth Fund have done reasonably well. They might have done a lot better if the fund had launched a few months earlier. After five flat years, China's nascent stock exchanges roared back to life in 2006, gaining more than 100% in 12 months. However, this bounceback has been tempered by a New Year correction; during the past week Chinese markets have lost about 7%.

Nevertheless, this is a long-term fund that promises returns of about 20% a year on the back of China's highly resilient economic growth of 10% a year and a maturing market profile. Economists expect Chinese growth to maintain growth of about 10% in the coming year. Inflation has been kept in check, at about 3%.

For AMP, Fidelity, Aberdeen or any other funds attempting to make money for international investors in China, volatility will always be an issue. It's no surprise many of the China funds are given the same marketing treatment as hedge funds: the high risk is often offset with a capital guarantee.

AMP's unlisted China fund has a three-year guarantee, which promises investors their money back in three years' time if the market collapses during the term of the guarantee. In contrast AMP's new listed fund does not have a capital guarantee; it does, however, offer several hallmarks of alternative investing, including high fees. The fund has an MER (management expense ratio) of 1.77% and a generous 20% performance fee for returns over the benchmark S&P/CITIC 300 Total Return Index.

No fund manager employed to make money from a China fund will admit it, but regulations, standards and statistics issuing from the Chinese markets are still unreliable by Western standards. Moreover, the short history of the modern Chinese stockmarkets (there were stockmarkets in China before the Communist revolution in 1949) is riddled with rampant speculation.

Although fund managers will reassure investors that Chinese now like to invest through managed funds, it's worth knowing that 1.3 million broker accounts have been registered since the beginning of 2007, compared with three million during calendar 2006. In other words there are alarming signs of speculators flooding back into Chinese stocks after last year's powerful performance.

Apart from these pressures on China's stockmarket is the presence of a Chinese-style Communist government that can accelerate or decelerate the pace of economic activity at any time. Recent comments by a senior party official at the National People's Congress, that only 30% of Chinese listed stocks were “good enough to invest in by Western standards” is firm evidence that the Government will regularly move to interfere with the market.

In other words, investing in China is high risk. During the evolutionary stage of the Chinese markets it should be viewed not so much as a foreign investment but as an emerging market or alternative investment.

Still, assuming that the statistics issuing from the Chinese markets are even indicative, it is an exciting area that promises strong returns. Here's why:

• Return on equity for 20,000 Chinese companies rose from 3% to 15% between 1998 and 2004, according to the Chinese Bureau of Statistics. Fund managers believe the ROE of China's listed companies is closer to 17%.

• The one year forward price/earnings multiple of Chinese companies is estimated at between 17 and 20 times '” low by historic standards.

• Some of China's greatest companies have successfully listed on Chinese exchanges in recent months. In every case these listings are dramatically oversubscribed. Recent listings include a leading Chinese bank, ICBC, and the nation's biggest life insurer, China Life.

• In common with alternative investments, China stocks have a “low correlation” with Western exchanges. This should mean Chinese returns are stronger when Western markets are weakening or vice versa.

The interview

James Kirby: Australian retail investors have been able to invest in China through managed funds for years. What's different about your new fund?

Karma Wilson: Our fund is listed on the ASX. It's the first of its kind. AMP and other groups have opened China funds in the past; these are unlisted funds. The difference with the AMP Capital China Growth fund is that we have a foreign investor's licence '” we are the only Australian fund to have this licence '” it allows us to directly buy shares in Chinese listed companies.

So you can buy anything you like '” you don't have to bother buying proxy-style “H” class stocks on the Hang Seng Index in Hong Kong, which was he traditional route for fund managers investing in China?

That's right. We can buy Chinese “A” shares listed in China, although we are restricted to the extent that our licence allowed us to invest a maximum of $US200 million only under a quota system. We have now pretty much invested that money in China.

What have you been able to buy that Australian investors could not access previously?

There are many companies listed in China, especially in the consumer and industrial sector, that are great stocks and you just cannot buy them unless you have our licence.

Can you give some examples?

Sure, the two I would mention are both global leaders in their respective businesses. China International Marine Containers is one of the biggest container movers in the world. Zhenhua Port Machinery is another one of the world's biggest companies in its category.

Now Chinese stocks had a great year last year. The benchmark S&P/CITIC Index rose 127% over the past 12 months. Can it repeat that performance in 2007?

Well, 2006 was a recovery year. It was a rerating of Chinese stocks and I don't expect we'll get a rerating again in 2007. Having said that, we would expect the market to rise by 20% in the year ahead.

How much are you paying for the stocks in your fund?

Well, many investors might not realise it but because the Chinese stockmarket is just coming out of a very flat period '” where prices were soft for five years '” price/earnings ratios are reasonable by international standards. The market is trading on a one-year foward P/E of about 16.5 times. On a historic basis, the P/E is around 24 times against a long term 10-year average of 30 times.

Do you think the market will rise back to that “historic” average of 30 times?

It's possible. As it stands, the market is delivering very strong earnings growth so we are quite comfortable with the valuations.

With this government-imposed limitation of $US200 million, your fund is effectively a closed-end fund (a fund that will not be taking in new investment funds beyond reinvesting profits). Is there any chance your quota could be extended or you could pick up the rights to buy more shares through a takeover of another fund?

Well, the quotas are highly specific and they are still being filled out by the funds that made it on to the lists. We don't expect it to be increased in the foreseeable future.

The Chinese stockmarket was flat for five years to 2006. Until very recently I would imagine more investors have lost money than have made money in Chinese stocks. How can these investors get enthusiastic about China mainland listings again?

Well things have really changed. There has been enormous regulatory reform in the Chinese market that is lifting the trading standards to international level. Along with that, more and more Chinese investors are participating in the stockmarket.

But Chinese investors participating more in the market is hardly a step towards a more mature market. I believe the number of new broking accounts is rising rapidly. Would that not mean more speculation?

Well, actually we have been reassured about the growing maturity of the Chinese investment market because they are increasingly using managed funds to access the market.

But isn't it a fact the lack of accounting and corporate standards, mixed with speculation, has led towards a casino-style exchange in China?

The reforms in Chinese markets have been dramatic. But perhaps a better way to look at is to watch the rise of dual listings. We've seen some really important dual listings of leading companies on the Hong Kong market and the Shanghai market. Now this shows you that the standards are becoming harmonised; it just would not have happened years ago when the standards between the two markets were so different.

Can you explain what you mean here '¦ and how it makes a difference?

Well, Hong Kong originally emerged as a market where Chinese companies were traded by international investors. It meant those investors could have access to both Chinese investments and global standards of regulation and governance, which operated in Hong Long. Now you are getting dual investing of leading companies. The first big one was ICBC last year; it was a huge success, many times oversubscribed, and the success of that listing has triggered a run of dual listings. The biggest financial services group in China, China Life, followed ICBC and in the coming weeks we're going to see Ping An Insurance, which is due to list at the end of February.

In fact JP Morgan recently predicted that we'll see 80% of the leading Hong Kong-based Chinese “H” stocks dual-listed in Hong Kong and China.

How many stocks is that and how long will it take to happen ?

Well in fact its only about 10 stocks. The figure 80% was representing 80% of the capitalisation of the Chinese companies listed in Hong Kong, so we are talking about the biggest companies. It will be done fairly quickly '¦ by the end of the year.

Eureka Report Editor James Kirby worked as a financial reporter on the South China Morning Post in Hong Kong during the 1990s, covering the first phase of global investing in Chinese “H” shares on the Hang Seng Exchange.