Some Believe Best Route
To China Is Indirect One
By CRAIG KARMIN
Staff Reporter of THE WALL STREET JOURNAL
It boasts the world's biggest population and one of its fastest-growing economies. But many investors are still
wondering when they are ever going to make money in China.
The question is surprising, given China's popularity as a magnet for corporate investment: In the 1990s, China
attracted more than $300 billion in foreign direct investment, second only to the U.S.
And yet for international portfolio managers, China has represented something akin to the Internet craze. As with
the tech boom, investors in China have been drawn to a grand idea full of promise, but one that has been clouded
by hype, tainted by corruption and accompanied by disappointing stock-market returns.
"It's a gigantic market, but there are few ways to play it," says Dave Linehan, an Asia-Pacific fund manager for
U.S. Trust. "I don't think you can find 20 investible names in all of China."
The result is that many investors are looking beyond China's borders as a way to gain exposure to its locomotive
economy -- investing in, say, Taiwan stocks that have mainland exposure.
The frustration over how to play the China market is widespread among fund managers, even though China's two
main markets, in Shanghai and Shenzhen, trade companies with a combined market capitalization of more than
$500 billion, leaving China trailing only Tokyo as the biggest Asian market. But many of China's hottest initial public
offerings sold abroad have given up most or even all their gains, while valuations for Chinese stocks trading
domestically are among the loftiest in the world despite questions about their quality.
Part of the problem is that China stocks are fragmented into several different categories and classes, each with its
own peculiarities. China's so-called Class B shares -- listings that were created for foreign investors -- have been
widely shunned even by emerging-market managers, who complain that the stocks are illiquid and the companies
are poorly run. Most are state-owned enterprises in which the government sold minority positions in hope of bailing
out faltering businesses.
China stocks have also been marked by extreme periods of boom and bust rarely seen outside the dot-com arena:
Shanghai's B-share index, for example, soared 92% in 2001, driven in large part by Chinese investors who
circumvented the restrictions. Last year, the index tumbled 33%, even as the Morgan Stanley Capital International
emerging markets index fell 8%.
Most U.S. investors interested in China have bought H shares, or mainland companies that list in Hong Kong or
New York and comply with international accounting and governance rules. Electric utility Huaneng Power and oil
producer CNOOC, for instance, are up more than 70% since going public in 1994 and 2001, respectively. Those
success stories, however, have been the exception. The H-share index peaked in 1993, when it was five times as
high as it is today. Most H shares trade at or below their IPO price.
China Telecom, one of last year's biggest China offerings, had to cut its IPO in half and lower the price to get the
$1.4 billion deal done. Nevertheless, the shares, which also trade in Hong Kong, have slipped 2% on the New
York Stock Exchange since pricing at $18.97 in November.
Beijing announced last month that it is opening the domestic-only A-share market to foreign investors. Yet strict
requirements -- such as the regulation that money managers must have no less than $10 billion in assets and must
hold any Chinese stock for at least one year -- have dulled enthusiasm. In fact, only about 10 foreign investors have
expressed interest in even applying for a license to buy these shares, according to Shanghai Stock Exchange
officials. Approvals are expected by April.
Stock valuations that tower over the rest of the world's also have been a deterrent. Years of falling interest rates,
government propaganda about the benefits of stock ownership, and reportedly widespread manipulation by local
brokers trading on their own accounts propelled the Shenzhen A-share market seven times higher between 1996
and mid-2001. Even after a 40% subsequent decline, notes Goldman Sachs, the Shenzhen A-share index trades at
more than 100 times trailing earnings.
All of which is why many fund managers are concluding that the best way to participate in China right now -- and
perhaps for a while to come -- is indirectly: owning Taiwanese, South Korean, Singaporean and other Asian
companies that have moved facilities to the mainland to take advantage of low-cost production or export a bulk of
their sales there.
Asian companies that have moved a significant portion of their production to China have slashed their costs and
improved margins. Goldman Sachs says it has identified 388 companies "that have a meaningful percentage of sales
to China or manufacturing activities in China."
The brokerage firm recommends Johnson Electric, a Hong Kong-based electronics company with 80% of its
manufacturing in China, and Hon Hai Precision, a Taiwanese computer parts maker with 70% of manufacturing in
China. But as investors drive up the prices of the most popular outsourcing names, investors have been turning to
smaller companies recently set up on the mainland.
Fang Zheng, a portfolio manager for the New York hedge fund Neon Capital Management, points to two
outsourcers with market capitalizations of around $1 billion: Lite-On IT, a Taiwanese manufacturer of CD-burner
equipment for International Business Machines whose shares rose 10% last year to 98.5 New Taiwanese dollars;
and BYD Co., a Hong Kong-listed maker of cellphone batteries that sells to Motorola and Panasonic. Its share
price has jumped 30% to 15.40 Hong Kong dollars since its IPO in July.
Marc Faber, head of his own investment company in Hong Kong and author of the book "Tomorrow's Gold:
Asia's Age of Discovery," prefers to gain exposure through companies that will service China's growing demand for
products, commodities, and travel: plywood and energy producers in Indonesia, for instance, and hotel and leisure
companies in Thailand, where Chinese have moved up to the Southeast Asian country's second-biggest tourist
group.
"One day," he says, evoking China's glorious future, "there will be an equivalent to Procter & Gamble in China. But
for now, I would play it by owning companies that are outside of China."
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