Tuesday, September 11, 2012

Is 25% Allocation To China Too Risky?

China has clearly been a very volatile market in the past few years and very often, that has been marked by important declines. That is bound to happen over and over in China but I would still argue that China should be a significant portion of your portfolio holdings if you have a long term horizon. My main point would certainly not be that it will be a smooth ride but rather that it is almost certain that over 30 years or so, the Chinese market will rise more quickly than US and other developed markets. If that is the case, wouldn’t you want to have at least 25% of your holdings in China?

Am I crazy to think that even holding 30-40% of my assets in China could be a great decision?

I’ve written about my convictions regarding Chinese internet stocks but I think that Chinese stocks will also tend to overperform significantly over the next couple of decades. What makes me think that?

Rapid economic growth: You might know that stock markets do not track the economy, especially in the short to medium term. However, as the Chinese economy overtakes the US and becomes the focus point of the world economy. I agree that on a GDP per capita basis, China will still remain well behind most industralized nations but in a nation of 1.3 billion people, the best performing companies are certain to do well. A company such as Baidu has the potential to be at the center of ecommerce in China, and many more leaders will emerge over the next few years. I would argue that the explosion of the economy will lead to incredible profits for the market leaders in dozens of different markets. Those are the companies that you want to own.

No debt: China and other emerging economies have one big difference with other leading economies, they have basically no debt which in a world where Europe and the US are becoming increasingly fragile. China will have incredible opportunities to buy valuable assets from desperate nations in Europe and abroad. I think it will also help China invest at home to help those companies that will be able to create jobs.

Attractive valuations: Because of the fact that few investors currently hold Chinese assets and that the risk (especially for those investing with a shorter time frame) is more important, the valuations are much more attractive. For example, the forward P/E of Chinese stocks is below 10 while US markets continue to trade at a 13 forward P/E or so. Over time, as China becomes more established, that difference will narrow and the earnings of Chinese companies will no doubt increase much faster than US ones.

Solid dividend yields: While US companies have generally been decreasing the portion of their earnings that they pay out, companies in emerging markets continue to pay out high dividend payouts making them very attractive for dividend investors. If you compare at FXI for example, which invests in the 25 largest Chinese companies to the Dow Jones Industrial average (30 blue chip US companies) you will see:

FXI: 3.88%
DIA: 1.87%

That is a staggering difference and the difference is comparable if you take broader indexes. I’ve talked many times about the benefits of international diversification and clearly China would be near the top of the list of places that dividend investors should look for.

Less exposure to European banks: If you have been following the news lately, you will remember that many of the largest banks in the world have been very volatile because of their direct and indirect exposures to sovereign bonds. Take the example of Morgan Stanley which does not hold huge positions in Greek bonds but it has large interests in French banks that do have those exposures. That has caused Morgan Stanley to be highly volatile. Emerging countries banks and China in particular tend to have much smaller exposures to the type of issues that the world economy is currently facing.

Strong currency: The Chinese Yuan continues to be under the radar in terms of world trade although it is quickly gaining importance. The US government has made it crystal clear that it thinks the Yuan is massively undervalued but the Chinese government is looking to let its currency appreciate only very slowly over the years so that it can adapt to a stronger currency. That will have a very big impact on all Chinese assets that will also benefit from this appreciation. Add to that the fact that the Yuan is likely to slowly become a second “reserve currency” which will also add tremendous pressure upwards and I can only imagine how much more the Chinese Yuan will be worth 10 or 20 years from now.

Disclosure: None

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