Why China Looks Like a Buy .
By BEN LEVISOHN
"A diamond with a flaw is worth more than a pebble without imperfections," goes the ancient Chinese proverb. That same thinking might apply to China's stock market.
For a country that is expected to be an engine of global growth for decades to come, China has a long list of immediate concerns. The economy is slowing. Inflation is climbing. The real-estate market may be in a bubble. And charges of accounting shenanigans have soured some investors on Chinese stocks.
Those are some of the reasons why the MSCI China index has risen just 3% since the beginning of 2010, compared with 20% for the Standard & Poor's 500-stock index.
And yet, despite its many problems, now might a good time to invest in China. "At the moment, people are saying it's over," says Hugh Simon, manager of the Dreyfus Greater China fund. "But China still has growth potential."
Why take the plunge now? Even a struggling China is expected to see its economy expand by 9.6% in 2011, according to the International Monetary Fund. While that is down from 10.3% in 2010, it could account for more than 30% of the world's total. On average, the IMF expects the global economy to expand by 4.3% this year.
And the Chinese government is taking steps to stimulate growth further, from cutting taxes on the poor and middle class to funding public housing. That, in turn, should prop up construction spending and boost consumer spending.
Meanwhile, data suggest that China's consumer-price index, which rose to a post-financial-crisis high of 6.4% in June, may be cresting. China's money supply, known as M2, dropped to 15.1% in May, the lowest level since May 2005—an indication that less cash is sloshing around in the system and that inflationary pressures may be ebbing.
If inflation tapers off, China's stocks could get a boost. While rising inflation makes real profits worth less, and usually causes stock valuations to drop, falling inflation makes profits worth more and often makes valuations rise. Most famously, in the U.S., inflation fell for most of the 1980s and 1990s, and the stock market soared. Similarly, when China's inflation rate jumped from 3% in November 2003 to 5.3% in July and August 2004, the MSCI China index rose just 2.2%. A year later, inflation had fallen to 1.3%—and the market was up 24%.
What's more, while China's inflation rate is clearly too high, its 9.6% economic growth gives it more latitude to attack the problem via monetary policy. In the U.K., by contrast, inflation is running at a 4.5% clip, despite economic growth of just 1.6%. Even in the U.S., inflation is running at an uncomfortably high 3.6%, despite an economic growth rate of just 1.9%.
Likewise, China, like Europe and the U.S., has a debt problem. On May 31 China agreed to provide as much as $436 billion to cover bad loans made to local governments, an amount equal to about half of the U.S.'s Troubled Asset Relief Program of 2008. But China also has a trump card that others don't: $3.2 trillion in cash reserves, by far the biggest hoard in the world.
"There are bigger problems in the U.S. and Europe," says David Semple, director of international equity at money manager Van Eck Global. "I would be worried about those things, not what's going on in China."
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