How to Make Money In China with FXI

| April 14, 2008 | 0 Comments

I was golfing with a good friend of mine a few weeks ago.  He’s a hedge fund manager in California and I convinced him to fly in for the day . . . for a round of golf.  It was on the course where I got some insight into investing in China.

I picked Matt up from the airport and after a quick breakfast we headed for the links.  It was a beautiful day in Phoenix and the sun was shining bright.  Our 10:00 am tee time was rapidly approaching.  We coated ourselves in sunscreen and took a few swings on the driving range.  We were ready.

Now, I’m not a great golfer.  But I always have a great time shooting a round with friends.  We drink a few beers and talk about the usual topics.  Life, family, and most of all — money.

A successful hedge fund.

Matt’s running a very successful hedge fund.  His success seems to grow every year.  Matt used to be an investment banker.  He lived in Asia for a few years and spent a great deal of time in Hong Kong and China. What he observed was amazing.  Every time he made it back to the States we would get together.  I would marvel at yet another story of exotic travel and business opportunity.

His travels put mine to shame.

Knowing that Matt is an expert on the Asian markets and China in particular, I asked him about the downturn in the market.  He just smiled. He didn’t need to say anything . . . I could read his mind.  It’s a great buying opportunity.

A few months back, when the Chinese market was at the top, many professional investors still recognized value in the market.  If they recognized value back then can you imagine what they see now?  Now, I know what you’re thinking.  The stories of sky high price to earnings ratios are everywhere.  Some P/E ratios in China reached 60, 70, and even 80.

How can professional investors still find good buys?

In the US markets, companies have historically traded at a P/E ratio of around 15 to 20.  Chinese markets were considered very expensive by comparison.  But that ignores a very important driver of value.  Growth.

The secret to investing in China is nothing earth shattering, despite what you see on the internet.  It’s in the growth rate.

Now before you shake your head, let me give you a quick example.

If you were to buy an average stock listed on the US exchanges you would pay somewhere around 15 to 20 times earnings.  So for every dollar of earnings the company has the stock is worth between $15 and $20.  A company with $2.50 in earnings would be worth around $50 per share ($2.50 x 20 = $50).

In China the stocks were trading for 60 or 80 times earnings.  So a Chinese company earning $2.50 and trading at an 80 multiple would cost $200 ($2.50 x 80 = $200).  Seems kind of expensive right?

Not so fast.

The important piece of information that investors overlook is growth.  In the US, a decent earnings growth rate is around 5% to 10%.  A US company with $2.50 in earnings might grow to $2.63 or $2.75.  In China a growth rate like that would be laughed at.

Some companies in China have a growth rate of 70% or 80%.  No, that’s not a typo.  This is the growth that gets professional investors very excited.  Our Chinese company with $2.50 in earnings would suddenly be making $4.25 or $4.50 the next year.  And best of all, the growth rate is expected to continue for some time.

You can imagine the value of an investment after 10 years of growing at that rate.  Even at half that rate the prospects are very enticing.

So, how do we make money from this?  My choice right now would be the iShares FTSE/Xinhua China 25 Index Fund (FXI).  It provides good exposure to China through the top 25 companies in the country.  The top five holdings include China Mobile a large mobile phone company, Petro China the largest producer of oil, China Life providing insurance, and two banks, Industrial & Commercial Bank of China and China Construction Bank.

FXI peaked in November 2007 around $220 and is trading at $140.  This is a 36% discount and I really think it’s a great buying opportunity for long term investors.  And I think Matt might agree.

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Category: Foreign Markets

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The Dynamic Wealth Report works with a number of staff writers and guest experts who specialize in everything from penny stocks to ETFs to options trading. These guest analysts post under the 'staff writer' moniker for ease of use.

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