Investment
managers & WEALTH Advisors
May 8, 2006
This is the May 2006 monthly Wealth Management newsletter
from Hoffman, White & Kaelber Financial Services, LLC. If you do not wish to be included in our
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Feel free to forward this to any of your friends who may find it useful. Thanks
for your interest and I hope you enjoy the letter.
Are You Itching to Invest in China’s Growth?
If you’ve been following the dynamics of
global trade lately, the statistics suggest that China is leading the world as
an exporter (seller) of goods and that the US is the world’s largest consumer
(importer). This isn’t really new news,
yet, if the direction of global capital flows represents a good indicator of
economic growth opportunities, wouldn’t this lead you to believe that investing
in China
makes a lot of sense?
During this
past month, I corresponded with my good friend and client, John. John emailed me out of the blue with: “we need to invest in China…any ideas?” For a number of reasons, John’s question
startled me. Yet, he had put forth an
excellent question that, in my opinion, could not be answered easily through a
couple of brief e-mails.
To set the
stage, John is a very busy medical professional who barely has time for social
activities and much less time to study finance.
Yet, I thought his observation about China was very astute. He also inquired about investing in
alternative fuels…
In my response
to John, I complimented him on exhibiting good instincts in seeking to uncover
an investment opportunity. At the same
time, however, I expressed that it is also very important to consider how and
when you take advantage of opportunities that will determine whether you win or
lose.
With global
capital flowing into – or through – China, I certainly do believe that there
is an investment opportunity to consider.
However, how exactly, does one take advantage of it? Will opportunities come from
currency – in the form of an appreciating Renminbi (the Chinese “People’s
Currency”)? Will it come from an
empowered business environment? Or, will
it come from an exploitation of their relatively inexpensive labor?
As readers of our newsletter well know, wealth management is
the ultimate goal of all that we do at Hoffman, White and Kaelber. Yes, we also promote our services; yet, you
will find that we always seek to present thought provoking topics that are
relevant to our wide audience.
This month’s letter will explore the “China Machine” as an
investment opportunity and how you might want to consider exploiting it. Following that, do you think a highly
diversified and conservatively managed portfolio returning 15.22% over the last
12 months is desirable? If so, please be sure to spend some time
looking over our market comment and performance at the end of this letter. It will be well worth the investment.
Is China
a Currency Play?
Since the
beginning of this decade, China's
booming economy, fueled by large inflows of foreign direct investment (FDI) and
rapid export growth, has emerged as a significant force in the global
economy. In 2003, China surpassed the United
States as the world's largest recipient of FDI, and its
foreign exchange reserves surged to nearly UD$820 billion by the end of last
year, second only to Japan.
Both inward
investment and export growth continues to create strong demand for China's
currency, the Yuan (also referred to as, Renminbi). All things being equal, such demand pressures
should cause the Yuan to appreciate relative to the U.S. dollar and cause China's
external position to return to balance.
But all things are not equal.
From 1994
through mid-2005, China's
Yuan, stood at the de-facto peg of 8.28 to the dollar while its economy roared
ahead. On July 21, 2005, the People's Bank of
China (PBOC), the country's central bank, began a new policy of calculating the
Renminbi's value against the US dollar using a weighted average of the prices, given
by major banks. The prices are pegged to
a basket of currencies representing their biggest trading partners. The list is comprised of: the US Dollar, the
Euro, the Japanese Yen, South Korean Won, the UK Pound, the Thai Baht and the
Russian Ruble. The highest and lowest
offers are excluded from the calculation.
If the ramifications of the prior paragraph aren’t clear, let me
explain: the market effects of supply
and demand remain very controlled at present.
In fact, several US
politicians are arguing that the Yuan is artificially low, giving Chinese
exporters an unfair advantage, contributing to US trade deficits and hurting US
labor markets. Nevertheless, the Chinese
government is not anxious to let their currency float freely anytime soon.
From my
research, the consensus suggests that the stance of China's Communist Party-led
government will not change, despite the broadening of its global trade surplus
and its buildup of foreign exchange. It is
expected that Beijing
will continue to allow only gradual moves from its prior Yuan peg against the
dollar and is loath to increase the Yuan enough to dampen growth in its coastal
factories. Exports are a key source of
jobs in a country that must find employment for tens of millions of the poor
farmers and workers laid off by bankrupt state factories in the continued
transition from communism to capitalism.
To appease
its major trading partner, last July, China
bumped up the value of the Yuan by 2% against the US Dollar, somewhat
diminishing tensions with the United
States.
But in the months since, the Yuan has appreciated less than 1% more
against UD Dollar. Still, some
economists believe that China's
reserves are now growing so huge as to compel the central bank to deliver a more
significant revaluation. Time will tell…
Should You Be Investing in Chinese Companies?
Few can
deny that the growth potential of China is vast. The country's success is dazzling, investment
inflows are huge, and the society is being transformed in a monumental economic
achievement. Because of this, China's
potential for investors appears significant, but the market poses a number of
unique political and cultural risks.
To better
understand the China Machine, let us begin with a passage from the CIA World
Fact-Book: “For centuries China stood as
a leading civilization, outpacing the rest of the world in the arts and
sciences, but in the 19th and early 20th centuries, the country was beset by
civil unrest, major famines, military defeats, and foreign occupation. After World War II, the Communists under MAO
Zedong established an autocratic socialist system that, while ensuring China's
sovereignty, imposed strict controls over everyday life and cost the lives of
tens of millions of people. After 1978,
his successor DENG Xiaoping and other leaders focused on market-oriented
economic development and by 2000 output had quadrupled. For much of the population, living standards
have improved dramatically and the room for personal choice has expanded, yet
political controls remain tight…
…Economic
development has generally been more rapid in coastal provinces than in the
interior, and there are large disparities in per capita income between regions…One
demographic consequence of the "one child" policy is that China is
now one of the most rapidly aging countries in the world. Another long-term threat to growth is the
deterioration in the environment - notably air pollution, soil erosion, and the
steady fall of the water table, especially in the north. China continues to lose arable land
because of erosion and economic development.
China
has benefited from a huge expansion in computer Internet use, with more than
100 million users at the end of 2005.
Foreign investment remains a strong element in China's remarkable expansion…”
In November
2001, with China's
entry into the World Trade Organization, the Chinese government made a number
of specific commitments to trade and investment liberalization. This began opening the Chinese economy to
foreign firms. Yet despite these moves toward privatization, much of China's
economy continues to be controlled by large State Owned Enterprises (“SOEs”),
many of which are inefficient and unprofitable. Rather than undergo a
large scale effort towards privatization, a restructuring of the SOE sector has
been a major priority of the government and one of its biggest challenges has
been the banking sector. Many Chinese banks have had to write off large
amounts of delinquent debts from state-owned enterprises and China's banking sector remains a
key concern for the country's economic stability as the ratio of problem loans
appears to be rising.
Layoffs
have played a large role in the restructuring of the SOEs, as many were
severely overstaffed. This has created
unemployment, which has been a burden on the government budget due to their
providing social benefits which were previously the responsibility of the SOEs.
At the same time, the geographic concentration of privately-owned
industry in the urban centers along the coast also has created additional
social strains.
As a result
of its effort, China's
real gross domestic product (GDP) grew at a rate of 9.8% in 2005, 9.5% in 2004
and 9.5% in 2003. For 2006, real GDP growth is forecast to drop to 8.9%
as a whole. Much of the GDP growth rate
appears to have come from excessive spending on capital goods and construction,
particularly in the SOE sector.
Given China's
booming economy – if you haven’t been scared off – how does one invest in
Chinese companies without risking unacceptable losses?
Aside from trying to acquaint yourself with specific companies or industries,
stock shares resemble a veritable alphabet soup. They range from "A," "B,"
and "C" to signify types of shares traded on the Shanghai and Shenzen
exchanges to "H," "N," "L," and "ADR"
to denote shares traded on the Hong Kong, New York, and London exchanges and
under the American Depository Receipt agreement.
Traditionally, A shares are held only by residents of China and are traded in Yuan. B shares are denominated in Yuan but payable
in foreign currency and are designated for foreign investors. C shares are wholly owned by state-owned
enterprises and are not publicly traded.
In June 2003, China approved
a handful of qualified foreign institutional investors, or QFIIs, to invest in
“A” shares listed in Shanghai
and Shenzhen.
To qualify for “A” shares, a financial institution must have US $10 billion in
assets under management in its past fiscal year. Fund management companies must have a minimum
of five years of operational experience, while insurance companies and
brokerages are required to have at least 30 years experience and paid-in
capital of at least US $1 billion. To
keep a rein on “hot money” escaping China and prompting a financial
crisis, the QFII scheme also requires funds to be held onshore for at least one
year before being repatriated.
Among the “H” shares, the highest rated are known as "red chips" and
they come in two varieties: mainland Chinese companies with Hong Kong
subsidiaries and Hong Kong companies that do the bulk of their business with
mainland China.
For most investors, the best way to play China is through a mutual fund. And, the number of fund offerings is growing
as investor demand for China-related products increases. But remember, it’s not like investing in the US
markets. China is a volatile economy. Investing in China is very risky, suitable only
for long-term investors, and should be limited to a small portion of your
portfolio. The things we take for
granted, like investor laws, private property, and accounting standards, won’t
protect your investments there. To some,
this may be considered more risky than the US penny-stock market…
Should You, Instead, Be Investing in China’s Economic Growth?
China is the world's second
largest economy on a purchasing power parity basis and is driven by a population
of 1.3 billion people. And, it is
estimated that China
enjoys a household savings rate of more than 40%, one of the highest in the
world. As incomes rise, newly empowered
consumers represent an enormous market potential.
For example, an estimated 4 million mobile phones are sold in China each month, the world's
biggest market with nearly 250 million subscribers. That's just 19 percent of the population and
sales in the last two years have reportedly increased 17 percent. And, from the CIA Fact-Book passage previously
referenced, we also know that the Chinese have embraced computer technology and
internet use.
Noted
economist and advisor to several US
presidents, Dr. John Rutledge, had this to say about investing in China’s
economic growth:
“The re-awakening of China
is the biggest economic storm system of our lifetimes. The opening of China has created an incredible
growth machine… China
is a category 5 hurricane, gobbling up the commodities and capital it needs to
feed its ferocious growth. This increase
in demand is the major force driving world commodity and product markets today.
For example, China’s
growth, not Iraq,
is responsible for the run-up in oil prices; it is also the driver of the
surges in steel, aluminum, and coal prices last year. It’s also generating huge increases in sales
and profits for the companies selling the materials and capital goods China
is buying to expand their economy. That spells opportunity for investors.”
According
to Rutledge, “if you’re invested in big U.S.
companies, you’re already invested in China. Many big companies…have made
direct investments in China
and plan to invest billions more.”
To back
this up, in March of this year, China’s
Ministry of Commerce, released statistics that foreign direct investment (FDI)
into China
from January to February totaled US$8.6 billion, up 7.8 per cent year-on-year. Hong Kong the British Virgin Islands – an
offshore haven for US managed money – and South
Korea topped China's major foreign investment
sources. China attracted US$60.3 billion in
FDI last year, down slightly from the record of US$60.6 billion posted in 2004.
In 2004 and 2005, Japan, South Korea,
Taiwan, and the United States were China's most important sources of
FDI.
Below is a
list of China’s
top imports and trading partners:
|
China's Top Imports ($ million)
|
|
HS #
|
Commodity
Description
|
Jan.-Nov. 2005
|
% Change*
|
|
85
|
Electrical
machinery & equipment
|
156,237.7
|
21.5
|
|
84
|
Power
generation equipment
|
86,943.5
|
4.5
|
|
27
|
Mineral
fuel & oil
|
57,925.3
|
35.2
|
|
90
|
Optics
& medical equipment
|
44,695.9
|
22.0
|
|
39
|
Plastics
& articles thereof
|
30,356.0
|
19.8
|
|
28, 29
|
Inorganic
& organic chemicals
|
30,149.1
|
19.2
|
|
72, 73
|
Iron &
steel
|
29,583.3
|
13.8
|
|
26
|
Ores, slag
& ash
|
23,539.0
|
51.2
|
|
74
|
Copper
& articles thereof
|
11,824.2
|
25.5
|
|
87
|
Vehicles
other than railway
|
10,915.5
|
-8.9
|
|
*Percent
change over Jan.-Nov. 2004
Source: PRC General Administration of Customs, China's Customs Statistics
|
|
China's Top Trade Partners ($ million)
|
|
Rank
2005
|
Country/Region
|
Jan.-Nov. 2005
|
% Change*
|
|
1
|
United States
|
191,585.5
|
25.4
|
|
2
|
Japan
|
166,985.6
|
10.3
|
|
3
|
Hong Kong
|
120,484.6
|
20.7
|
|
4
|
South Korea
|
101,457.7
|
24.7
|
|
5
|
Taiwan
|
82,042.8
|
15.8
|
|
6
|
Germany
|
57,079.4
|
16.8
|
|
7
|
Singapore
|
29,618.2
|
24.0
|
|
8
|
Malaysia
|
27,525.6
|
15.6
|
|
9
|
Russia
|
26,529.7
|
37.3
|
|
10
|
The Netherlands
|
26,226.0
|
38.4
|
|
*Percent
change over Jan.-Nov. 2004
Source: PRC General Administration of Customs, China's Customs Statistics
|
For 2006,
the US-China Business Council summarizes “some analysts do not see China's
export-driven growth decelerating much in 2006. Hang Seng Bank forecasts that exports and
imports will each grow 25 percent in 2006. Others are more measured in their
outlook… These estimates are based on the assumption that the global economy
will be weaker in 2006…and that rising domestic costs especially in land, raw
materials, and minimum wages will place significant cost pressures on
exporters, which already operate on thin margins.”
Some Concluding Thoughts
John
certainly asked me an interesting question and, since he moved from Charlottesville, we
haven’t had much time to visit with one another lately. Yet now, I hope it’s clear to John and our
other faithful investment clients, when reviewing their portfolio holdings, that
we’ve been invested in China’s
economic growth engine for some time.
And, it sure has helped our returns.
And, John,
if you want a single stock play, you might want to take a look at 3Com (symbol:
COMS). 3Com also is the majority owner
of Huawei-3Com Co., Ltd. (H-3C), a China-based joint venture formed by 3Com and
Huawei in November 2003. H-3C brings
innovative and cost-effective product development and manufacturing which has a
strong footprint in China. I own some, personally, but not in my client
portfolios. Too risky…
Hoffman, White & Kaelber Financial Services Investment
Performance Update
This April was certainly upbeat for most of the major
markets we track. All but the Russell
2000, S&P Technology sector and S&P Health Care sector indices showed
positive gains for the month. The
largest performers were Gold shares, the MSCI South Korea index and the S&P
Energy sector index registering gains of 12.03%, 6.32% and 5.04%
respectively. This represents unusual
volatility toward the upside. A 12% gain
in gold for the month! Wow! It certainly wasn’t a global inflation threat
moving gold, or was it?
Our hard work continues to reward us. For the month ended April 30, 2006, our
one-month performance is up 2.18%, our one-year return is up 15.22%, our
three-year return is up 10.64% and our average annualized return since
inception is up 10.99%. Our since
inception risk measures remain very conservative at +/- 5.45% (+/- 3.88%
and +/- 5.56% for one-year and three-year measures, respectively) and our
Sharpe Ratio (reward for risk taken) is a very enviable 1.61 (2.91 and 1.51 for
the last 12 and 36 month periods, respectively). For more performance
information, please see our web site for details.
Is a comfortable retirement or preservation of wealth important to
you?
Want better long-term results from your investments?
Choose Us As Your Investment Manager!
Research us on the web at www.hwkfs.com