In The News
Does the "Butterfly Effect" have a China connection?
11/28/2004
By Sam Ali
Newark Star-Ledger
Remember the "butterfly effect," the brain tickler students were asked to ponder in high school physics class?
A butterfly flutters its wings in a remote part of the world and triggers a whole series of events that result in a twister tearing through Texas.
In terms of the economy, nowhere is this phenomenon more evident than in China.
China's demand for beef, cotton, crude oil, iron ore, copper, zinc, gold, diamonds and nickel have been so explosive, it is virtually impossible to design a serious investment strategy without a solid grasp of the China connection.
Last year, China built so many buildings and roads, it consumed 40 percent of the world's cement production. It also inhaled 30 percent of the world's iron ore and 25 percent of its aluminum, according to research by Stephen Roach, chief economist at Morgan Stanley in New York. The list of raw materials goes on and on.
Anyone lucky enough to have snapped up shares in companies that produced those raw materials, such as Rio Tinto, one of the largest mining companies in the world, certainly has felt China's butterfly effect. To them, the Chinese economy has been hotter than Szechuan chili paste.
But if there is one lesson investors are learning fast, it is this: Just because China's economy is on fire -- Gross Domestic Product grew 9.1 percent last year, nearly triple the U.S. rate, and is expected to grow another 9.4 percent this year -- doesn't mean Chinese stocks are.
Case in point: China Life Insurance, the world's biggest initial public offering in 2003, rose 35 percent on its first day of trading on the New York Stock Exchange. This year, it is down 23 percent.
Similarly, Internet portal Sohu.com, one of the first mainland firms to list on the Nasdaq back in 2000, rose a whopping 361 percent in 2003, but has fallen nearly 50 percent this year.
More broadly, the Morgan Stanley Capital International China Index, which tracks the performance of companies located in China, soared 81 percent in 2003, but is pretty much flat year to date. And the USX China Index, which tracks China-play companies listed on U.S. stock exchanges, is also trending flat -- a major momentum shift from a year ago, when the index posted a 104 percent return.
Welcome to the world of emerging markets.
China is often compared with the post-Civil War American economy, which in the 1860s was the premier emerging market of the world and one prone to wild boom- and-bust cycles.
As with any emerging market, the Middle Kingdom remains a very high-risk marketplace, rife with debt-plagued companies. Corruption is rampant. Piracy and counterfeiting are a way of life, and the murky regulation of its financial markets would make New York Attorney General Eliot Spitzer's head spin -- factors many investors seem to overlook in their quest to milk this golden calf.
The country's political stability is another risk factor investors need to keep in mind. Despite its newfound yen for Western-style capitalism, China remains a Leninist dictatorship, and the government has a tight grip on all business dealings.
Despite all the caveats, ravenous investors hoping to get a piece of the action parked a total $1.41 billion in mutual funds that invest in Chinese stocks as of Oct. 30, according to fund tracker Lipper Analytical Services.
"In absolute dollar terms, $1.4 billion is trivial, but in percentage terms, it's amazing because it has doubled in size since 2002," Andrew Clark, senior research analyst at Lipper, said.
So far this year, eight mainland China firms have debuted on Nasdaq, and 10 more are planned during the next several months, according to Reuters. The New York Stock Exchange is home to 18 Chinese firms, most of them state-run enterprises largely controlled by the Communist Party, including China Life Insurance, China Mobile and PetroChina.
"The few that are willing to come over and live under U.S. regulatory and legal standards are the cream of the crop," said Tim Halter, managing director of the USX China Index, which is expected to launch an exchange-traded fund devoted exclusively to Chinese companies traded on U.S. exchanges. "There are many more companies that want to list here, but they just can't get U.S. auditors to sign off on their financials."
At this point, many experts don't think it is wise for the average investor to put too much money directly into China or the country's stocks -- unless they have nerves of steel and a very long time horizon.
Rather, investors might be better served looking outside China for investment opportunities that latch on to the China theme, said Jeet Dutta, a mutual-fund analyst at Morningstar, a Chicago-based financial research and data firm.
Think butterfly effect: mutual funds that focus on resource-rich countries in Southeast Asia or Latin America, or on global companies that stand to benefit from the Chinese industrial revolution.
"That seems to be the safest way to play into the Chinese growth story," Dutta said.
For those investors who want a direct stake in China -- and who can stomach the risk -- there are Chinese-focused mutual funds. According to Lipper, the 15 China funds it tracks had average returns of 6.7 percent so far this year.
Some of the top performers in this category include the T. Rowe Price New Asia Fund; the Matthews Pacific Tiger Fund, which is up 14.2 percent year to date; and the William Blair International Growth Fund, which invests in a broad range of foreign growth companies of all sizes, including developed and emerging markets.
While it is easy to see China as the promised land, experts caution investors not to overdo it.
Yes, China is the future, and its long-term prospects are excellent. But Clark said no more than 10 percent of an investor's holdings should be in emerging markets, including Asia.
"I would do it purely for kicker purposes," he said. "Any more and the risk is probably too great for the average investor."
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