The Year of the Dragon
Investing in the biggest market the world has ever seen

by Briton L. Ryle

It’s finally time to bid 2001 a not-so-fond farewell. The first year of the 21st century will not be missed. Remembered, yes. But not missed.

All eyes are on 2002 with expectations of an economic turnaround. Even a modest acceleration of corporate spending will keep the Dow and the NASDAQ in rally mode. In fact, I think NASDAQ 3,000 is very likely this year. We may even see 3,500.

But even though the Dow has held up pretty well, I don’t see any way it can break out to new highs over 12,000. I expect the Dow to be range-bound between 9,500 and 11,500.

I believe the big story for 2002 will be China. China’s entry into the WTO will have profound effects on the global economy. We could be looking at a paradigm shift as the U.S. loses its worldwide economic dominance. For that reason, I’m calling 2002 the Year of the Dragon.

Western arrogance

China is officially a global player now. And its economy should be the world’s biggest in 5 years. Maybe sooner. Yet western businessmen act like a bunch of five-year-olds at a birthday party, and China’s a giant piñata, one whack away from spilling its goodies.

The party may not end nicely. But investors who understand the situation, and make the right moves, could make insane amounts of money.

The dragon awakens

China’s 1.3 billion people are about to take the global economy by storm. And that could be a devastating blow for regional export economies. China already attracts 80% of the direct foreign investment in Asia. Once China becomes "safe," it’ll attract even more. And that’s bad news for countries like Taiwan, Vietnam, Cambodia, Malaysia, the Philippines and, to a lesser extent, South Korea, Singapore, and Indonesia.

Not many consider China a threat to the world economy. But let me ask you this: Why do you think President Clinton threw a clause into the U.S.-China WTO agreement that would allow the U.S. to erect protectionist tariffs?

The good student

China’s been quietly learning about capitalism and the global economy for the last 20 years. In stark contrast to its image as a rogue communist country, China’s been a model member of the World Bank… and its biggest customer since 1993. The World Bank reports that China makes very accurate budget forecasts for projects, finishes them on time, and repays loans very promptly. A lot of "progressive" Western countries should be so responsible.

Same goes for the IMF. Loans have been repaid promptly. And China has actively sought advice from the IMF about the convertibility of its currency. China’s track record on the global stage suggests it will be ready when free trade arrives.

Underestimating China could be one of the biggest blunders in history. Which, of course, means seeing China’s potential could be one of the most lucrative decisions an investor can make.

And I’ll tell you why.

China looks like Europe and America did…right before the Industrial Revolution!

Ninety percent of China’s 1.3 billion people are farmers. Labor costs are incredibly low. Competition for jobs is high. In Shanghai and Beijing, the ratio of applicants to jobs runs around 5 to 1.

Companies are extremely competitive because wage pressure is virtually nonexistent. Urban unemployment is 10%. The workforce is eager to learn marketable skills. Domestic trade has few regulations.

Plus, there’s virtually no inflation, despite 8-10% GDP growth for the last ten years running. Estimates are that China’s economy will continue to grow at that clip for the next ten years. GDP is US$1.2 trillion and should double in ten years.

And China’s currency is remarkably stable, due in part to massive foreign reserves created by China’s consistent trade surplus. China holds US$181 billion in foreign reserves (the 2nd highest holdings in the world). It can and will aggressively protect its currency with this money.

In 2000, China’s trade surplus with the U.S. alone was US$84 billion. It seems likely to top US$100 billion in 2001.

It’s all about the cash

China’s prime motive for joining the WTO is money. The simple truth is, despite its dynamic economy, China doesn’t have the capital resources or the know-how to bring its infrastructure into the 21st century.

China needs an across-the-board upgrade. Roads, bridges, utilities, banking, stock markets, and telecommunications–everything needs to be modernized. And to accomplish this, China is looking West.

Several Chinese companies have taken advantage of Western capital markets to fund their growth. In 2000, US$21 billion in foreign capital made its way into the country.

Think globally, buy locally

The number-one rule for successful investing in China is this: buy locally. Buy the domestic companies that are positioned to take advantage of a surge in domestic demand. I’m talking pure plays, baby.

At present, pure plays on China are pretty limited. There are a grand total of 7 Chinese companies listed on the New York Stock Exchange. Amazing for such a big country. Chile’s got 17 companies listed in the U.S., fer cryin’ out loud.

I’ve examined every opportunity. I believe the recommendations that follow are the best ways to profit from China’s emergence into the global economy. Among the trends I want to take advantage of are: the rise of the middle class, modernization of utilities, telecommunications, and investment banking.

A Brilliant Investment

The biggest shopping mall in Asia just opened in Shanghai. The US$335 million Chia Tai Square covers 240,000 square meters.

Wal-Mart is opening a Sam’s club-type store in Beijing and plans several more. Plus 3 shopping centers in Beijing over the next several years.

Even Tiffany’s sees opportunity in China. The retailer to the rich and famous will be opening a 1,200 sq. ft. store in the lobby of the Beijing Palace Hotel in December.

During the first half of 2001, individual housing loans, which have only recently been made available, reached 26 billion yuan, or 2.4 times as much as in the same period last year. Home loans are expected to triple to 80 billion yuan by the end of 2001.

What’s all this tell you? Chinese people have money in their pockets, and they want to spend it.

Statistics from the state administration of taxation show that US$4.62 billion in personal income tax was collected during the first half of 2001. That’s an increase of 32% compared with the same period last year. And it means residents’ income is rising fast, since tax on wages comprised more than 40% of the total income tax.

Probably the single most important trend for investing in China is the rise of the middle class. I know it’s obvious, but economies can’t grow if people don’t spend money. And I believe a growing middle class is one of the underpinnings of China’s lofty GDP growth numbers.

Right now, China has 50 million middle-class citizens. The ranks of the bourgeoisie are expected to quadruple to 200 million in 5 years. Mao must be rolling over in his see-through grave.

The growing middle class is already having an impact.

Official figures show that over 10 million Chinese tourists went abroad last year, spending a total of US$10.6 billion.

The road to riches

China’s not so backward that consumers will go gaga for transistor radios and microwaves, either. Chinese want computers and cars. And I believe the domestic automobile industry will be one of the first to benefit from free trade.

The market

One in ten Beijing households now owns a car. That’s around 500,000 privately owned vehicles in Beijing alone. By the end of the decade, it’s estimated that as many as 300 million Chinese will own cars. That’s some serious growth.

China built more than 2 million automobiles in 2000, taking the 8th spot internationally. According to the China Association of Automobile Manufacturers, this year’s sales of automobiles will reach 2.35 million units, up roughly 30% over last year. An investigation by China’s consumers association showed that in the next five years, 32% of consumers intend to buy cars.

Currently, the selling price for an economy car tops out around US$12,082.

Shanghai Volkswagen, makers of the country’s most popular saloon model, the Santana, dominates the Chinese car market. The German-Sino joint venture has cornered around 35% of the market.

And Volkswagen’s not alone. In fact, just about every automaker in the world has partnered with a Chinese company to take advantage of this huge market, though none have been as successful as Volkswagen.

Audi, Ford, Mercedes–you name it, it’s there. In fact, some analysts say GM cares more about the Chinese market than its home base, the U.S.

But I believe China Brilliance Automotive (CBA:NYSE) has enough irons in the fire to give VW and the others a run for their market share.

About Brilliance

Brilliance China Automotive Holdings was established to own a 51% interest in Shenyang JinBei Passenger Vehicle Manufacturing Company. Brilliance was the first Chinese company to be listed on the New York Stock Exchange.

Brilliance is the leading manufacturer of minibuses in China. Unit sales should rise 10% to 65,000 in 2001. But the big engine for growth will be Brilliance’s passenger car line.

Brilliance introduced a pilot car to the Chinese market in December 2000. Developed and designed entirely by Brilliance China Automotive, the Zhonghua is the first automobile to be produced exclusively by Chinese engineering efforts.

A brilliant future

In addition to manufacturing its own passenger car line, Brilliance is due to begin manufacturing SUV’s and trucks this year in a joint operation with GM. Plus, Brilliance is in talks with BMW about a possible joint venture, which would put Brilliance front and center in the luxury car market.

You may be surprised to learn that the luxury car market is alive and well in China. Audi is the market leader, and is on pace to sell 28,000 cars this year. Prices range between US$108,000 and US$168,000. Figures like those make you realize that capitalism is alive and well in China.

Buy Brilliance Automotive (CBA:NYSE) as a pure play on China’s domestic consumer market. It’s a thinly traded stock, but you should have no trouble buying below US$23.

All the Oil in China

Reagan and Bush Sr. got their eyes blackened by Oliver North and the Iran-Contra arms deal. Clinton turned up with a shiner after a nasty blow below the belt. But I can’t wait for this next one to hit the headlines.

I’m thinking something along the lines of "The Opec-Osama-Russia-China deal." Bush and Putin are the main players in a back-room arrangement that will land bin Laden in U.S. Federal Court (if he’s lucky), open massive Russian and Chinese oil fields to intensified exploration, and keep OPEC from adopting production cuts for the foreseeable future.

Maybe I’m too conspiracy-minded. But even if I’m wrong, Petrochina still represents a tremendous opportunity in the 3rd-largest energy market in the world

China’s black gold

China is the 3rd largest energy producer in the world, and the 2nd-largest consumer behind the U.S. China’s massive oil fields account for two thirds of domestic use.

State-run Petrochina (PTR:NYSE) controls roughly one half of the oil and gas reserves of Exxon Mobil. And yet it trades for 1/8th the price. It pays a huge dividend, nearly 10%. 2000 earnings of US$6.7 billion–that’s more than double Toyota’s profits.

Petrochina needs oil to sell for US$25-$26 a barrel to match that profit in 2001. This is unlikely. But Petrochina has another angle that hasn’t started to pay dividends yet.

I’m talking about natural gas.

The methane program

China believes that inflation is the single greatest threat to political stability. The currency is stable. And wage pressure is nonexistent. So the most likely source of inflation is energy costs.

China is dependent on oil imports and coal. The government believes diversification of energy resources is key to mitigating the potential inflationary effects high oil prices. It’s working hard to build up oil reserves. But the other half of the equation is natural gas.

Coal is by far the leading energy source at 70%. Natural gas makes up just 2% of the energy used in China every year. The government wants to raise natural gas to 8% of the total in ten years. Central to this strategy is the construction of a 2,400-mile pipeline from Xinjiang province to Shanghai. The project will cost US$14 billion.

Exxon, Shell and BP Amoco sank US$2.7 billion into Petrochina and the no. 2 oil company, Sinopec (SNP:NYSE), in 2000. Exxon Mobil and Royal Dutch Shell are in talks to take a minority interest in the project.

Petrochina: the world’s cheapest integrated oil company?

Petrochina trades at a massive discount to other major oil companies. Exxon’s P/E is 16 and it trades at 3.5x book and over 1x sales. Chevron has a P/E of 11 and currently sells for 2.5x book and 0.8x sales.

With a P/E of 4, price/book of 0.9 and price/sales of 1, PetroChina is valued at a significant discount to its peers. And it also boasts the highest net margins of any major integrated oil company in the world.

But wait. There’s more…

Petrochina pays a huge dividend–nearly 10%. Which makes it a great income stock. Assuming the dividend doesn’t get lowered, you’ll make half your investment back in just 5 years.

And once the "risk premium" for China is removed, you can bet income funds will take positions in this high-yield stock. That will drive the price higher and provide strong price support.

Based on valuation alone, Petrochina could trade as high as US$45 a share. Buy Petrochina (PTR:NYSE) at or below US$20 a share.

China Unicom

With 1.3 billion people, China’s the biggest market in the world for just about anything you can think of. And that’s part of the reason why it’s such a tantalizing opportunity.

The problem is that there aren’t very many ways for the average investor to play the Chinese market. Most if us don’t have trading accounts in Hong Kong. But that may actually be a good thing.

You’d have to be very familiar with the Chinese markets to avoid getting wiped out. Stocks make huge moves on unsubstantiated rumors. Insider trading is rampant. And creative bookkeeping is not uncommon.

China is making great strides in legitimizing its markets, but for the time being, foreign investors (that’s us) will do well to stick to the big companies with U.S. listings. That also means it’s important to focus on the large demographic trends.

And cellular communications is a good one.

Winging the Wong number

As you might guess, not a lot of Chinese have cell phones. Shanghai has the highest penetration rate in China, around 30%. Compare that to the 70% penetration in Hong Kong and you can see that even a modern, on-the-go city like Shanghai has tremendous room for growth.

In China as a whole, the potential for mobile telephony is huge. There are 136 million cell phone users, compared to 123 million in the U.S. 100,000 new subscribers sign up every day. Estimates say there will be 230 million users by 2004.

The flood of new subscribers should keep the new phone market strong, with 30-50 million phones sold a year for the next few years.

Wireless subscriber rates are slowing in the U.S. and Europe. There are only so many potential customers left.

Not so in China. China’s cellular market will be strong for years to come. And China Unicom is the best way to play the inevitable growth here.

Inside the numbers

Despite dropping over 30% in 2001, China Unicom still trades at a slight premium over U.S. wireless carriers. I consider the premium to be a growth charge.

In the areas where China Unicom operates, penetration rates will end the year at around 17%. China Unicom controls around 16% of the market. But reports say that Unicom is quickly gaining market share from incumbent China Telecom.

Perhaps that’s why China Unicom is already planning to add capacity to its just-finished CDMA network. Current capacity is 15 million. With the added capacity, Unicom’s network will handle 35 million. Unicom currently has around 23 million customers.

When China Unicom hits 35 million subscribers, which realistically could be sometime next year, revenues will close in on US$5 billion. That, in turn, puts China Unicom’s forward P/E somewhere around 25. That is very reasonable, considering Unicom’s growth rate.

Buy China Unicom (CHU:NYSE) at or below US$12. I’m setting a one-year price target of US$19.50.

Putting It All Together

Investing in foreign markets is not easy. It’s tough to dig up information. And you’re always dependent on secondary sources to get a feel for the investment climate. That’s why many investors prefer letting someone else manage their investment money. They buy a fund.

I’m including a fund here, Liberty Newport Greater China Fund (NGCAX:AMEX). But not because I believe it’s safer or easier than investing in the stocks I’ve already discussed. I’m recommending this fund because it has something you can’t get anywhere else–financials.

The Liberty Newport Greater China Fund is heavily weighted toward financials, which account for 31% of the fund’s US$33 million. The next highest sector is services at 16%.

Banking on banks

I mentioned earlier that I wanted to invest in banking, specifically investment banking. Because China’s going to have one of the hottest IPO markets the world has ever seen. And Chinese investment banks will be like Pied Pipers for what could literally be thousands of IPOs over the next few years.

Right now, there are only 1,200 publicly traded companies on the two Chinese exchanges. And all but around 120 of them are owned by the government. Total market capitalization of China’s stock markets is just US$600 billion, or roughly half of GDP.

That’s pretty good for a stock market that’s just ten years old. And China’s got the 2nd-largest stock market by capitalization in Asia, after Japan. But Japan’s market is 5 times bigger.

That’s a massive disparity. And one that won’t last. Experts say that China’s stock market capitalization could surpass Japan’s in as little as ten years. That’s 500% growth in a decade.

Now, there will be plenty of opportunities as China’s stock market grows. But we can say right now with confidence that investment banks will do well. There’s almost no way they can’t.

Chinese investors

Corruption in the Chinese markets is so rampant that even Chinese don’t invest there. Total household savings are a whopping US$845 billion. Nearly a trillion dollars, sitting in the bank, making 1.8% after taxes. A tragedy.

China’s undertaken a host of reforms to clean up its stock markets. And that’ll go a long way to tapping the nation’s savings. Because Chinese have no place to put their money to work. There are no government bonds. And interest on savings is negligible. When Chinese citizens have real choice in a clean stock market, a flood of investment capital will come pouring in.

And that’s the final piece missing from China’s economy.

It’s all fund and games, till someone loses an IPO

The Liberty Newport Greater China Fund has been around since May of 1997. It’s had the same manager since inception. It has a three-year growth rate of 12%, even though it’s down 14% over the last year.

I view recent weakness as a great opportunity. Expect to see 20%-plus appreciation in 2002.

Buy the Liberty Newport Greater China Fund (NGCAX:AMEX) as a proxy for China’s burgeoning IPO market. Buy it under US$16 with a one-year price target of US$20.