Time to Think Small on China

05/05/2009 9:02 am EST

Focus: GLOBAL

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

An exchange traded fund for Chinese small caps looks more attractive than the "A" list of state-owned giants, writes Carl Delfeld, editor of Chartwell Global ETF Report.

Economists at Goldman Sachs [recently] raised their forecast for China GDP growth this year to 8.3%, from 6%, the latest in a series of such upgrades. "In the next three quarters, we expect domestic demand growth to further strengthen, bolstered by loose financial conditions and continued policy stimulus," the economists said in the note announcing their revision.

By contrast, Standard Chartered Bank's economists maintained their forecast of 6.8% growth for China this year, saying that although major infrastructure spending had helped China's economy bounce back in March, "we wonder about the sustainability of this rebound."

There is also growing caution among China watchers about the huge rally seen on China's stock market this year. The key Shanghai Composite index has soared 37% since the start of 2009, far outpacing other major markets. [It was up almost 41% as of Monday's close-Editor.] A report by China Asset Management, the country's largest fund manager, cautioned this week that valuations had "overshot corporate fundamentals," and that "speculative trading is now driving the market," Bloomberg News reported.

[Yet] China has proved skeptics like me wrong in weathering the global downturn surprisingly well. Growth has fallen to an annual rate of 6%, but this is impressive given how much worse it might have done in light of a 44% plus fall in exports. In response, markets have really taken off since its infrastructure stimulus measures were announced earlier this year.

At this point, I am still wary of the Morgan Stanley China A Share Fund (NYSE: CAF), which is trading at an unusually high premium to its net asset value, but recommend looking at the Claymore/Alpha Shares China Small Cap ETF (NYSE: HAO), which targets small- and mid-cap companies listed on US exchanges. I like HAO for several reasons:

1.  HAO is largely populated by private companies, not owned or controlled by the government. In contrast, of the top 35 companies listed on the Shanghai exchange, 34 are controlled or owned by the central government.

2. HAO trades at a multiple of seven times earnings, three times cash flow and 0.7 times book value.

3. For large-cap China ETFs like FXI, the top ten holdings can account for about 50% of total assets. For HAO, the top ten represent just 17%.

I still recommend an 8% trailing stop loss and rate this as a high-risk position. (It closed at $18.29 Monday-Editor.)

Subscribe to the Chartwell Global ETF Report here.

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