Two Reasons to Buy China-Based Stocks

How do you make a 100% gain in a foreign stock even if the price of the shares go nowhere in their home market? It’s all in the currencies. To have any chance of doing that, you have to start with a cheap currency. For U.S.-based investors, one of the cheapest currencies may be China’s yuan (or renminbi).

Of course, China fixes the value of the yuan against the dollar at the moment. This is a big bone of contention between American and Chinese officialdom. The charge is that China is holding the value of its currency down to make its exports cheaper.

Whatever the outcome of that spat, it seems as if some currency appreciation is inevitable over time. The market anticipates a 3% increase this year. And in the past, China has let its currency appreciate gradually. For example, the value of the yuan rose 21% from July 2005 to 2008, before China stopped it. (What happened to commodities during this stretch is also worth knowing, and we’ll get to that below, too…)

So how cheap is China’s currency now? It is hard to say. Murray Stahl, the savvy investor who runs Horizon Asset Management, thinks it might be as much as 50% undervalued.

One way to look at this, though this hardly ends the debate, is through the famed Big Mac Index. It simply shows you how much it costs to get a Big Mac in different parts of the world. Based on this, one of the cheapest places to get a burger is China.

Put another way, China’s renminbi is 49% undervalued versus the dollar. I don’t know if the yuan is that cheap, but it seems it is cheap to some meaningful degree. If it is that cheap, then U.S. dollar-based investors stand to make a huge windfall. As Stahl writes, “If [the renminbi] were allowed to float, one might expect returns of up to 100% from the currency exposure alone. For a U.S. investor holding Chinese securities, a rise in the value of the renminbi would provide positive returns, even if the local share price were to remain unchanged.”

That’s how you make 100% without the shares going anywhere. Regardless of what the exact percentages wind up being, playing for a rise in the yuan seems the way to bet.

The dollar has lost ground against a bunch of other Asian currencies already this year. It lost nearly 7% again the Malaysian ringgit, for instance. Singapore, which also pegs its currency to the dollar, recently said it would allow gradual appreciation. China, I think, will be no different.

For this reason, getting a yuan revenue stream is a good idea if you are U.S. dollar-based investor. One way to do that is to buy shares in a Chinese company that does business mostly in China and hence makes sales in yuan. (You don’t want an exporter.)

My sense of it is that the Chinese will allow a gradual appreciation of their currency, perhaps 4–5% a year. For investors in China, this is a meaningful tail wind. I don’t think it will have much of an effect on Chinese exports. China’s advantages are deeper than that. In 2005–08, when China’s yuan rose 21%, its trade surplus actually tripled. A stronger yuan will also make the oil and iron ore and other commodities China needs cheaper for Chinese buyers.

This brings us round to the question of what else might happen if the yuan gets stronger. In 2005, when China allowed its currency to appreciate, oil jumped 15% the month after the news. Commodities in general rose. As The Wall Street Journal explains, “With a stronger yuan, imported raw materials already in high demand in China — such as crude oil and copper — would become cheaper there.” Hence, demand rises! In particular, those commodities of which China is short — oil, potash, soybeans, iron ore — could all receive a jolt if the yuan gets stronger against the dollar.

There is another reason to own Chinese shares beyond just the currency. China is underrepresented in the world’s stock indexes. This is important because it helps give you some sense of where the big money — the institutional money — will flow in the future.

As Stahl points out, the Morgan Stanley Capital International EAFE Index is the most widely used global benchmark for investment managers. (EAFE stands for Europe, Australasia and the Far East.) That means the global index funds, ETFs and other funds all look to ape this index or beat it. Think of it as the global S&P 500.

Well, this index has zero allocation to China. Zero. China is the world’s second largest economy, and it has no weighting in this popular index. “In principle, this is rather unusual,” Stahl writes, “since the object of the index is to replicate world financial performance outside of the U.S. It is difficult to imagine how this is to be accomplished if China, given the size of its economy, is excluded.”

Where it is included, it is often a ridiculously small portion of the index. State Street Global Advisors has the MSCI All Country World Index. China is 3.3% of this index, the ninth largest weighting. Japan, by contrast, has a 15.5% weighting. Investors thinking they are getting something representative of the world in the World Index are quite clearly getting a skewed view of that world. If China got its proper weight, it would be 17% of the index.

The reason for the neglect is because there are not enough China securities to fill out these indexes yet. The tradable volume of China’s market is still small relative to the size of China’s economy. As the market grows over time and as more securities come to the market, this issue will likely solve itself. This, though, is your opportunity as a smaller investor. You can buy now before the buffaloes come thundering in.

As Stahl puts it, “We believe it is only a matter of time [before] China will ultimately be included in indexes at the appropriate weights. If this were to occur, one could imagine the impact on the Chinese securities prices, irrespective of the underlying economic backdrop.”

The impact would be large and to the upside. The key is you want to be invested in these companies before that happens.

The market, like Mother Nature, seldom hands out freebies, however. Investing in China is likely to test the linings of your stomach, if history is any guide. Over the past 30 years, the Hang Seng Index — a benchmark of China securities — has fallen by an average of 56% in six episodes lasting anywhere from two months to three years. Yet to the strongest stomach go the greatest rewards. The annualized rate of return on the Hang Seng Index was 11.5% in the 30 years ending December 2009, compared with the S&P 500’s return of 8.1%.”

Today, Chinese stocks have a couple of tail winds that will keep that streak alive, as I’ve discussed above. Besides, many of the U.S.-listed Chinese stocks seem cheap on the face of it, with single-digit price-earnings ratios, good balance sheets and 20%-plus growth rates — such as one of the stocks in the Capital & Crisis portfolio. Those low price-to-earnings ratios could stay low and investors would still earn 20%-plus a year just from earnings growth. If the market should up the multiple, you’d do even better. Add in potential currency effects and you could do better still.

Chris Mayer
Whiskey & Gunpowder

June 2, 2010