Checking Out China Funds

Checking Out China Funds
Managers still see solid opportunities away from Shanghai's frenzy. Here are five savvy playsby David Bogoslaw

Alan Greenspan may have warned of a possible "dramatic contraction" in Chinese equities in a May 23 speech, but investors appear so far to be unfazed. Despite the bubble talk, many fund pros are still focused on opportunities in the Middle Kingdom.

When investors think of opportunities to make money in China, companies riding the wave of huge exports are typically the first to spring to mind. But fund managers have begun to pay attention to stocks whose fortunes are tied more to growth in the domestic market, as the sizzling Chinese economy creates a widening population of eager consumers.

With China's economy growing at around 11% a year, investors are looking for ways to grab a piece of the action. Although the current Year of the Pig may excite investors with visions of becoming fat, happy, and prosperous, a note of caution is in order: Investors should be wary of gorging themselves amid what appears to be a stock-market bubble to many economists (see BusinessWeek.com, 5/18/07, "China Tries to Turn Down the Heat").

Consider the relatively new Shanghai Stock Exchange, whose composite index has jumped 50% since the beginning of the year. Some fund managers are steering clear of the index, warning that its sharp and sudden gains reflect a torrential inflow of domestic money with nowhere else to go at the moment. That's bound to change as the government's Qualified Domestic Institutional Investor (QDII) plan, which would allow a greater portion of domestic funds to be invested in other markets, gains traction, albeit ever so slowly. The government quota on how much money can be invested outside the country is a paltry $15 billion to $17 billion, chump change compared with China's $2.6 trillion economy.

With an eye toward prudence, some portfolio managers who wish to play China are sticking to stocks that list in Hong Kong, where transparency and corporate governance are far better than on the mainland. While economic growth is expected to moderate in 2007 due to slowing U.S. export demand, the continued rise in property prices is likely to support local investor sentiment in the months ahead, according to a May research note from Aberdeen Asset Management.

Obviously, investing in China carries notable risks. Investors who want some exposure to one of the world's most dynamic economies may want to do some homework first. With that in mind, this week's Five for the Money looks at a few funds with sizable exposure to China that remain open to new investors.

1. Guinness Atkinson China & Hong Kong Fund (ICHKX)
This $172 million fund has been making money by focusing on companies staking a claim in the infrastructure boom. That includes energy companies with ADRs trading on U.S. exchanges such as CNOOC (CEO), PetroChina (PTR), and Yangzhou Coal, and industrials such as Angang Steel and Dongfang Electrical Machinery.

Dongfang is one of the two largest domestic manufacturers of electrical turbines, which are in great demand in "a country installing the equivalent of the U.K. national grid every year," says Edmund Harriss, who has co-managed the fund since 1998.

He prefers Dongfang to its competitor Harbin Power, which he faults for over-diversifying, and points to Dongfang's slimmer balance sheet; cleaner, more straightforward business focus; and superior returns on investment.

In the auto industry, Harriss has been a buyer of Denway Motors, which, through a joint venture with Honda Motor (HMC), makes the Honda Accord and Odyssey for the Chinese market. There has been a general upgrade in the car models available to Chinese consumers; they're now as good as anything being sold in the U.S. or Europe, he says.

Harriss advises investors interested in China to avoid getting caught up in the vaunted huge growth story and instead to drill down into particular market niches, with the aim of finding those companies that have genuinely been generating high growth, beating their competitors, and capturing higher margins. The fund has a 70% weight in Hong Kong-listed stocks, with the other 30% invested in Hong Kong-based companies doing business in other parts of Asia.

2. Oberweis China Opportunities Fund (OBCHX)
Managed by James Oberweis since its launch in October, 2005, the China Opportunities Fund is taking cues from the explosion in consumer buying power on the mainland. Looking beyond the 20 largest companies favored by most institutional investors, Oberweis is buying up shares of second-tier companies that have strong retail potential.

"This is a country where the biggest consuming class in the world is likely to develop over the next 20 years, and it's already happening," he says. That creates an opportunity for retailers to develop brands—and they stand to profit nicely by doing it sooner rather than later.

Li Ning (LNNGF), which makes athletic shoes, is an obvious choice, since domestic sports-apparel manufacturers are well-positioned to go up against international rivals like Nike (NKE) in catering to domestic Chinese demand with their lower prices. But an equally savvy way to play the surge in consuming power is the advertising market, Oberweis says.

He points to the focused approach Focus Media (FMCN) is taking, targeting affluent consumers by placing flat-panel display screens in the lobbies of large office buildings in China's biggest cities. With a 95% market share in this area, Focus Media nearly tripled its sales in 2006 from the prior year, with sales expected to nearly double this year. Focus Media is a Chinese-owned company based in Shanghai, but its shares trade only as ADRs on the NASDAQ exchange.

Oberweis is also leery of shares trading on the Shanghai Stock Exchange and says the bulk of his portfolio is in H shares of Chinese companies, or those listed on the Hong Kong Stock Exchange, which can be bought for half the cost of Shanghai-listed A shares. Once the government's QDII scheme takes hold and is expanded beyond the initial quota of $17 billion, he expects prices of H shares to rise and prices of A shares to drop, as investors take advantage of arbitrage opportunities between the two markets.

"We're not buying for the arbitrage opportunities. We're buying because we think they're good companies. And [buying H shares] is the cheapest way for us to invest in those companies," he says. Oberweis has $825 million in assets under management.

3. U.S. Global Investors China Region Opportunities Fund (USCOX)
For 2007, this $90 million fund is pushing the theme of "asset-injection" plays as an easy concept for investors to wrap their minds around. Romeo Dator, who has co-managed the fund for the past five years, is betting on Hong Kong-listed names that are buying assets at hefty discounts to market prices from their government-controlled parent companies on the mainland. "It's a way for the parent company to realize the benefits of getting these assets off their books, and the government getting out of the business of owning some of these companies," Dator says.

The bonus is that this is happening mainly to resource companies at a time when the massive infrastructure buildup in China has stoked demand for these products. The stock price of China's premier copper producer, Jiangxi Copper, is up at least 50% since it bought cheap copper mines from its parent earlier this year. And coal producers China Coal Energy and China Shenhua Energy should see comparable gains after their asset injections, Dator predicts.

The China Region Opportunities Fund also favors health-care suppliers such as Shandong Weigao, a manufacturer of female sanitary napkins and other health-care-related products. Dator says he believes these stocks will benefit from the emphasis the Chinese government has placed on health-care spending in its latest five-year economic plan.

The fund's turnover rate was 200% in 2006, the result of the managers' decision to prune their holdings and take profits following dramatic runups in stock prices across the board.

4. Eaton Vance Greater China Growth A Fund (EVCGX)
Portfolio manager Pamela Chan is also a great believer in the profit potential of branding. She likes high-end department stores such as Ports Design, Peace Mark, and Parksons that have come to dominate the market thanks to strong brand recognition.

With the infrastructure development in China showing no sign of abating, she's also a fan of building-materials manufacturers such as Anhui Conch and China National Building Materials. These companies are benefiting from ongoing consolidation within the cement industry, which has been aided by government policy stressing sustainable growth. That has driven out highly polluting kilns, which had been a source of excess supply and low pricing in recent years.
Chan thinks the property sector is another attractive bet amid rising income levels and the ability of developers to increase their land-banks, she wrote in an e-mail message.

5. Dreyfus Premier Greater China A Fund (DPCAX)
Don Martin, president of Mayflower Capital, a California-based financial adviser, recommends this fund, which invests in midcap growth stocks. With 20% of its portfolio allocated to consumer-discretionary names, 17% to industrials, and 15% to financial companies, he sees Dreyfus' China fund as a safer bet than some other options that are too heavily weighted in financials and more vulnerable should the volatile China market crash.

To avoid the potential for capital-gains taxes of around 30%, which would be triggered if portfolio managers started selling off shares of stocks, Martin advises new investors who haven't benefited from the stock gains to buy through a fee-only planner that can get the load fee waived on these funds.

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china, foreign investment, mutual funds