Has China's Market Bottomed?

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As investors focus on the U.S. and European markets, one market flying under the radar is China. Despite posting some of the most robust growth in the first half of 2010, China's stock market has been one of the world's worst-performing markets this year.

But after barreling by about 27%, the benchmark Shanghai Composite index has risen close to 10% since July 5. Investors are betting that China's tightening efforts are ratcheting down, after China's premier stated last month that the government would refocus on maintaining strong economic growth.

Has China's market bottomed out?

Uri Landesman, president of multistrategy hedge fund Platinum Partners, had been bearish on China for the first half of the year – and he was dead on. Now he's changing his tune.

"China's looking much better to me," Landesman said in an interview: 

My sentiment has changed because [China's market] is a lot cheaper; plus we are five months further into them putting their very substantial heel on the neck of the economy. That said, I think we still have five months of very rough patch. So I think things are going to be better from here. It doesn't mean we've necessarily bottomed out yet, but it's definitely looking more attractive to me now than it was.

Landesman prognosticates if the Shanghai were to see another leg down it would be precipitated by fears of a global double dip mid-August to mid-October, which could cause the benchmark to trade down towards the 2,000 level from 2,575 now. "But I would be a massive buyer at that point because I still think we haven't seen new highs on the markets this year," he says.

Landesman expects growth in China to stabilize in the second half, as the Chinese government balances its stimulus measures with reining in credit excesses.

Anh Lu, portfolio manager for T. Rowe Price's New Asia Fund (FUND: PRASX  ) , said she thinks the correction is over. "We're quite constructive on China at this stage," Lu said in an interview. "We don't view [the rally] as a near-term pop because we're optimistic on the market for the foreseeable future."

But Lu cautions that it won't be a straight line up. "I think there are still a lot of challenges ahead for China, and this is not just a one-year thing," said Lu. "The next five years will bring major structural changes in China, which means there will be bumps along the way."

As China's economy matures, the pace of recent growth drivers -- exports and China's urbanization process -- will start to moderate, as global demand for goods tempers, with a major wave of infrastructure already built out. In turn, domestic consumption will make up for some of the slow down in exports and urbanization. As people get wealthier, and the infrastructure becomes sufficient, there won't as much need to build, and consumption should rise as they buy more things, eat better, and pay for more services.

Looking into 2011, Lu said she thinks company margins will revert back to more normal levels after climbing to historical highs in 2010, as companies cut costs and racked in revenue helped by China's massive stimulus package.

If there is a rapid run-up again in the second half of 2010, and valuations start to look stretched again, Lu indicated she would be less constructive on Chinese equities. "But at today's prices and what we see happening on the ground, we think the economy will be fine," she said. "It just depends where stocks are when we go into 2011."

Near-term risks
Two risks investors need to consider when investing in China is the state of the country's banking sector, and the possible overadjustment of policy response by Chinese authorities to stabilize economic growth. In the process of positioning itself for growth and warding off recession, China instituted low interest rates and alleged lax lending policies, which some experts warn have caused a speculative property bubble. Aware of this potential problem, China implemented reserve requirements for its banks and took measures to rein in speculation and overextended lending.

Landesman thinks China's banking sector still poses a systemic risk to China's economy at this point. In contrast, Lu believes the banking sector does not pose a systemic risk to China's economy, pointing to a low loan-to-deposit ratio across the sector of 75% and strong capital ratios of 10% to 12%.

Still, she admits, Chinese banks will most likely have to recognize some bad loans, which she expects will materialize sometime next year and into 2012. "But I think the banks have enough capital -- and at the same time, credit is still growing." Chinese banks have started to go public in an effort to proactively raise capital to cushion their balance sheets for potential bad loans.

The other risk is that as China's government tries to rein in overextended lending and slow the pace of creation of new buildings, it risks over-readjustment. "People have effectively stopped buying property," said Lu, who is on the ground in Hong Kong. "Companies have definitely started to slow down on some of their projects; property transaction volume has totally dried up. The risk is if everybody thinks property prices will to continue to decline, nobody purchases property for a year."

Investing in China for the long run
Regardless of short-term moves, China is still a smart bet for the long run -- and Landesman and Lu are both long-term bulls. Landesman favors domestic plays over exporters. Specifically, he likes the media and retail sectors within China.

Lu favors the consumption story as well. She believes domestic consumerism will naturally evolve into a major growth driver for China's economy. When measuring consumption levels against people's savings and absolute levels of consumption versus GDP, Lu said consumption is still very low: "... when GDP per capita gets to that $6,000 or $7,000 level -- and China's just starting to enter that space -- the rate of consumption starts to grow at a much faster pace than GDP growth. Those types of businesses will continue to do very well in China."

Within the sector, Lu favors consumer staples and consumer discretionary spending. "A lot of these businesses have pretty much established themselves as leaders in their segments now," she said. "I think it's going to be very hard for people to come and nudge them out." Within this sector, Lu favors grocery store chain Wumart Stores, tissue company Hengan International, and noodle company Want Want.

Lu also likes online businesses in the region like Sina (Nasdaq: SINA  ) , Internet search engine Baidu (Nasdaq: BIDU  ) , and online travel company (Nasdaq: CTRP  ) because of each company's continued strong growth. She also favors New Oriental Education (NYSE: EDU  ) , an education company that teaches people English as a second language.

For more on investing in China:

Fool contributor Jennifer Schonberger does not own shares of any of the companies mentioned in this article. You can follow her on Twitter. Baidu and New Oriental Education & Technology Group are Motley Fool Rule Breakers recommendations. Sina is a Motley Fool Stock Advisor pick. International is a Motley Fool Hidden Gems choice. The Motley Fool has a disclosure policy.

Read/Post Comments (1) | Recommend This Article (4)

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Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 21, 2010, at 10:07 PM, KBOKSOFT wrote:

    In reading investing headlines today, I have a certain feeling of déjà vu from the late nineties. In fact, it seems like if you took the headlines of 1999 and replaced "Internet", "Web" and "B2B" with "China" and "Emerging Markets" you'd have the headlines of today.

    Don't believe me? Consider:

    How much of China's success recently is fueled by the global perception of China's success? I am reading more and more articles about money pouring into Chinese investments – as a way of encouraging investors to pour money into Chinese investments. When you read something that says so-and-so super-successful investor just bought a zillion shares of a leading Chinese asphalt company, does that make you want to buy the same? Am I the only one who remembers that "follow the smart money" mentality more accurately referred to as "Irrational Exuberance"?

    Even in your craziest, hair-brained moment would you have considered buying stock in a corporation headquartered in a communist autocracy? Does it seem reasonable now that the media is saying other investors are doing it?

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