Chinese Growth ...

12/30/2005 12:00 am EST

Focus:

Paul Tracy

Editor, The StreetAuthority Market Advisor

"China is perhaps the most compelling economic growth story in the world today," says Paul Tracy in his StreetAuthority Market Advisor. But rather than risk individual stock selection, he suggests a basket of holdings through a China ETF. Here's his review.

"China is certainly not as wealthy as the US. In fact, the nation sports a per capita GDP of less than $6,000 or roughly 85% below the $40,000 per capita GDP of the US. The difference is growth. Most economists agree that, over the long run, the US economy is likely to post GDP growth of around 3% annually. That type of growth rate is very respectable for a large, developed economy.

"Going forward, we believe that China is on a growth curve similar to Japan's in the 1970s and 1980s or America's at the turn of the 20th century. A century ago, for example, it wasn't unusual for the US to deliver real economic growth of close to 10% per year. The simple fact is that countries tend to grow most rapidly in the early stages of development. As the country moved from being a primarily agrarian society to a global industrialized power, US manufacturing, industrial, and eventually service-sector businesses blossomed. These industries, in turn, then paid out higher wages that led to the emergence of a large middle class and the development of a powerful consumer sector.

"China is already headed along that very same roadmap. In fact, China's GDP growth has averaged close to three times that of the US over the past decade. And foreign companies have certainly taken notice, investing heavily in manufacturing capacity in the nation in recent years. Meanwhile, domestic Chinese firms, sometimes aided by foreign investment, have also expanded rapidly. The end result has been a growing middle class of Chinese consumers. Most analysts estimate the Chinese middle class to be over 300 million--about the size of the entire US population.

"As Chinese incomes rise, more consumers are demanding items like cars, modern electronics, and the latest fashions from the West. And apart from the consumer story, China is also seeing booming foreign trade. Eventually, China may reach a wealth level similar to what prevails in the US or Western Europe, and at that point its tremendous economic growth will likely slow. However, even if that scenario does unfold, that's still decades away; average growth in China will likely continue to trend higher than in the US for years to come.

"The key to investing in this promising hyper-growth market is diversification. All developing economies experience growing pains, and individual stocks can get pummeled during domestic market panics. By purchasing a basket of China's largest stocks in different sectors, you can benefit from the nation's impressive growth without the risk that a single underperforming stock could destroy your returns. The iShares FTSE/Xinhua China Fund (FXI NYSE) offers diversified exposure to China's 25 largest and most liquid companies. Financials, retailers, and energy concerns are all represented in the index.

"Thanks in large part to China's rapidly-growing economy, FXI has outperformed the S&P 500 since the fund's inception in late 2004. FXI offers broad diversification and access to a host of companies that would be difficult for individual US investors to buy directly. For example, many of China's best-placed companies trade in Hong Kong but do not trade in the US as ADRs. What's more, it's extremely expensive for individuals to trade stocks listed in Hong Kong; the iShares can, however, offer easy access to this market.

"Even better, you might think that China's impressive growth would make the nation's stocks extraordinarily expensive on a price-to-earnings basis. But nothing could be further from the truth, as the average holding in the iShares trades at less than 12 times earnings and 1.9 times book value. To put that valuation into perspective, consider that the S&P 500 trades at about 16 times earnings and 2.5 times book. By these measures, the S&P 500 is roughly 40% more expensive. As the Chinese economy continues to grow at a fast clip in the years ahead, this combination of excellent value and rapid growth should lead to outsized gains for investors."

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