How Should Investors Approach China?

04/16/2007 12:00 am EST

Focus:

Carlton Delfeld

Editor, The La Jolla Letter and Pacific Gains

Carlton Delfeld, president of Chartwell Partners, weighs the pluses and minuses of the China growth story and recommends how investors can participate while lowering their risk.

China is certainly not for the faint of heart. Last year from mid-May to mid-June the S&P 500 (SPY) dropped about 10% while the Chinese iShares FTSE/Xinhua China 25 Index (NYSE: FXI) fell 17.5%. But FXI ended up 84% for the year before dropping 10% in early 2007.

So, first you need to accept this volatility and believe it is more than offset by an oversized upside. You can also take measures to lower your risk, such as buying a put option (right to sell at a specific price) on FXI out as long as 18 months, before buying FXI. Think of this as China portfolio insurance.

Another option is to invest indirectly in the great China growth story through ETFs representing Singapore (Amex: EWS), Taiwan (Amex: EWT), Hong Kong (Amex: EWH) and Australia (Amex: EWA).

What attracts me to China as an investment opportunity is its economic growth rate plus its seemingly endless potential for growth--a bit like America at the turn of the 20th century. What repels me is its political system; shaky financial institutions and the sense that China clearly intends to replace America as the hegemonic power in the Asia-Pacific region-–not a good thing at all.

My guess is that [China’s leaders will be able to keep things together] through the 2008 Beijing Olympic Games. Eventually though, the contradictions in an authoritarian, one-party, state-driven big business model attempting to operate in a global market economy will just be too much and this huge speed bump may cause things to fall apart at the seams. The question is when: it could be a few years or it could be 20 years down the road.

Then there is the question of China’s competitive advantage, which up to now has been its low wages and cost structure. Fortune did an article on two of Tenneco’s plants that make the same product–-one in Shanghai and one 7,000 miles away in Litchfield, Michigan.

[As of 2005] the Shanghai plant had a monthly wage scale from $210 to $250 per month, while Litchfield’s was $1,880 to $4,064. But despite being of comparable size, the Litchfield plant produced 1.4 million units in 2005 compared with 400,000 in Shanghai, and total revenue for the Litchfield plant was more than three times that of the Shanghai plant. Operating margins were 30% higher.

This little story highlights the strengths of the American economy. In fact, the US is still by far the largest manufacturer in the world; with an output three times that of our nearest competitor, Japan. So, my bottom line advice is not to get carried away with ETFs like FXI.

It would for most investors be a mistake to completely ignore these opportunities. Consider these investments as speculative just like you would a micro cap company pursuing a new technology. It could become a ten-bagger or it could go bust.

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