Tuesday, September 7, 2010

Tuesday Q&A Series – China

This week’s questions come from Gus, a client who is interested in learning more about China as it relates to business.

Q. Even with the Chinese economy slowing down, it is still growing at a faster rate than ours. Is it wise to have a large percentage of our portfolios invested in their economy?

China’s current economic situation is compelling: According to the 2nd quarter numbers, China just recently passed Japan as the second largest economy in the world and it is also scheduled to surpass the U.S. GDP in nominal terms by 2027 according to Goldman Sachs projections. China’s ascent in world rank has taken place faster than most had estimated just a few years ago in part because of stagnating developed economies in the wake of the financial crisis of 2008. Even with the increases in nominal GDP, China ranks far down the list, barely scratching the top 100 nations in per capita GDP and producing only 10% of that of the United States on a per capita basis. So, there is still more potential in this growth story.

Rollins Financial approaches investments in China’s economy differently for each and every client, as each client will have a different acceptable allocation to Chinese securities. We do make investments directly in Chinese stocks through mutual funds and ETFs, but the majority of our Chinese investments are made through diversified emerging markets funds. Some academics, like Jeremy Siegal who was referenced in a recent blog, have suggested that because over half of the economic activity takes place outside of the United States, investors should allocate 50 percent of their portfolios to overseas investments. China’s GDP currently accounts for nearly 10% of worldwide economic activity. However, most investors are not comfortable with the idea of having over 50% of their investments targeted to overseas investments, with 10% specifically allocated to China.

Typically, a Rollins Financial portfolio allocation averages about 25% toward international investments while 5 to 10% is allocated to emerging markets like China. The main drawback to a more significant allocation to China is the added volatility inherent in Chinese securities. In 2008, the most widely traded Chinese ETF saw even more significant losses than the broad U.S. markets, but in-turn, the Chinese ETF rebounded more sharply than the S&P 500 in 2009. Investors, especially the more mature variety, will find that added volatility inherent in Chinese and other emerging markets uncomfortable and, therefore, deserving of a smaller share or their overall portfolio.

Q. Is there an increasing number of U.S. companies establishing their presence in China?

A common consequence of a financial crisis is an increased emphasis in protectionist policies as sovereigns try to insulate their economies from another crisis. Protectionism is largely a political reaction to constituencies who have been harmed or are under the perception that they have been harmed by other groups. This is evidenced by some actions China has taken to slow investments and progress by some well known U.S. corporations.

Coca-Cola tried to make an investment in the China juice market, but Chinese regulators rejected a takeover bid for a Chinese company. Had the deal been approved, Coke would only have had 20% of the total juice market there, so it seems the government was not concerned about a monopoly on the market. Google has also been grappling with how to expand their business in China since China still censors the internet. Early in 2010, Google announced that it may pull out of China because of a clash with the government only to seemingly reverse course this summer. And, of course, there is the never-ending issue of China manipulating its currency so their products will be cheaper in the rest of the world than they might be if the currency floated freely.

But the clear trend is for more free trade and more open markets, not less. Many well-known U.S. corporations have cited China as the fastest growing market despite some of the regulatory obstacles. McDonald’s has opened “Hamburger U.” in Shanghai where McDonald’s employees are given the opportunity to take business courses. Proctor and Gamble has cited China as the second largest consumer market in the world behind the U.S., as P&G plans multi-billion dollar investments in China. Currently P&G receives about 30% of its sales from the emerging economies like China. Apple recently opened its flagship China store in Shanghai and has plans to open 25 more stores in the next couple of years. Not all of Apple’s newest products are available yet in China, but they are just starting their endeavor in that burgeoning market.

Make no mistake: There have been a few instances of newly protectionist policies implemented in the wake of the crisis, but perhaps this is just a consequence of China’s communist legacy. However, companies from the U.S. and elsewhere are making significant investments in China as that still largely untapped market evolves.

Q. How is the Chinese totalitarian government relating to companies from democratic countries? Is there any danger of takeovers?

Anytime you are considering an investment in a communist country, there are always geopolitical risks to consider. The Chinese government is already a “partner” in most of the large publicly-traded Chinese companies listed on the exchanges. But there is a clear incentive for reasonable policies by Beijing. China relies on the U.S. and other foreign consumers to keep its population employed and manufacturing the products we want. Western consumers are in turn reliant on inexpensive goods from China. It’s debatable who has more to lose from a breakdown in this relationship, but we don’t envision any government moving too aggressively and jeopardizing this symbiotic relationship.

Gus, I hope my answers above have given you a better understanding of China and our views concerning investments there.

We encourage our clients and readers to send us questions for our Tuesday Q&A series at contact@rollinsfinancial.com. And as always, we hope you will keep Rollins Financial in mind when seeking professional advice on financial planning and investing.

Best regards,
Eddie Wilcox

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