A China fund moves cautiously

Updated: 2007-04-04 11:44


SINGAPORE -- On a recent visit to a Chinese mining company, mutual-fund manager Flavia Cheong asked the deputy chairman what kind of gross profit margin the operation earned.

"He told me it was 100%," she says. Her reaction: "It's impossible -- it costs something to take the coal out of the ground. Management clearly has no idea what their cost structure is."

The visit reaffirmed what she had thought for years: Investors should give Chinese-listed companies a wide berth. It is an unusual view for a stock picker who runs an offering named China Opportunities Fund.

The 39-year-old Ms. Cheong, who works for Scotland-based Aberdeen Asset Management PLC, says the majority of Chinese-listed companies, most of which remain state-owned, lack profit-driven management and thorough financial statements.

So for the past seven years she has stocked the fund's portfolio with companies that do business in China, such as Australian mining giant Rio Tinto PLC, or companies like wireless carrier China Mobile Ltd. and semiconductor-equipment maker ASM Pacific Technology Ltd. that trade in Hong Kong, where listing and reporting requirements are stricter than on the mainland.

That has meant some missed opportunities as China's stock markets boomed in recent years. The $700 million China Opportunities Fund, launched in 1992, gained 47% in the two years through Feb. 28, putting it in 51st place out of 53 China funds tracked by Standard & Poor's Fund Service. The average one was up 85%.

But as China's markets gyrated early this year, Aberdeen's circumspect strategy paid off. Investors began taking profits in January, sending tremors through Shanghai's red-hot stock market. On Feb. 27, a day after reaching a record, the Shanghai Composite Index fell 8.8%, its biggest one-day drop since 1997 when markets were rattled by the death of Communist Party elder Deng Xiaoping.

For the first two months of the year, Ms. Cheong's fund was up 3%, compared with the average China fund's 0.85% loss, according to S&P. Over the past month, the Shanghai index recovered from the February swoon, beginning another record run on March 21, after Beijing strengthened rules prohibiting companies from using share-sale proceeds to purchase stocks.

Aberdeen's China fund is available in Australia, New Zealand and parts of Europe and Asia, but Ms. Cheong's wariness offers a sober second thought for investors world-wide who have piled into the country's markets. Most small investors know little about Chinese companies or how they are run; they only know China is hot.

Investors from around the globe poured $22.4 billion into emerging-market mutual funds in 2006 and half of that -- $11.2 billion -- went into China funds, according to Emerging Portfolio Fund Research, a Cambridge, Mass., company that tracks stock- and bond-fund flows. That helped buoy the Shanghai Composite Index 130% last year.

Last year's market boom was fueled largely by China's financial sector. The initial public offerings of Bank of China Ltd. and Industrial & Commercial Bank of China Ltd. were among the most sought-after IPOs world-wide. Ms. Cheong, however, stayed away. The two banks listed in Hong Kong, and ICBC also listed in Shanghai.

"We look at the risk profile, the credit policy, the robustness of management. We felt that, if there was a shock, we didn't know if these companies are robust enough to withstand it," says Ms. Cheong, who works out of Singapore. "We also thought the valuations were pretty stretched."

Bank of China and ICBC are trading at about 2.3 and 2.7 times Aberdeen's estimate of those banks' 2007 book value, which in simplest terms is a company's assets minus its liabilities. Analysts often value banks on a share-price-to-book-value ratio. Korean and Taiwanese banks trade at about two times book value, as does U.K. banking and financial-services giant HSBC Holdings PLC.

Given the valuations, "there's no room for disappointment," Ms. Cheong says. And she believes there could be plenty of that. China's government is widely expected in the next year to deregulate the rates banks offer on deposits. "It's going to be very different when they have to compete for deposits," she says.

Her fund owns shares of China Merchants Bank Ltd., which listed in Hong Kong in September. This Chinese bank fits her criteria because "they've been in operation with the same management for 10 years, and they've managed the bank through at least one down cycle."

Aberdeen's cautious China strategy has served it well in past market routs. In 2004, when China's market dropped sharply after the government moved to rein in fixed-asset investments to cool the economy, the China Opportunities Fund gained 19%; the fund's benchmark at that time, the CLSA China World Index, dropped 3.5%.

Still, Ms. Cheong and Aberdeen's investment team did a lot of soul-searching last year, when Chinese stock markets raged and their fund was left in the dust. The firm's Asian funds are run by a team of 13 managers, with one manager taking the lead on each of the funds.

"It was stressful," she says. "We thought, 'Should we buy a whole basket of banks and just forget about it? Just buy four banks and hope one will be a winner?' "

They decided to stay true to their roots as a fund house that looks for long-term investments in stocks that trade at affordable price-to-earnings multiples, she says.

Analysts generally expect China's stock market to remain volatile. Merrill Lynch & Co. sees volatility for the first six months, but predicts "A" shares, or domestic Chinese stocks denominated in yuan, could rally 10% to 15% by year's end, and "H" shares, which are Hong Kong-listed shares of companies incorporated in China, could rise 20%.

Ms. Cheong estimates the Chinese economy will grow about 5% to 6% this year and next. She thinks corporate earnings, which were a bit lackluster in some sectors last year, will improve this year.

"There haven't been huge increases in capacity in many industries in the last one and half to two years," she says. "The auto industry, for example, hasn't seen a huge increase in capital expenditure. So we'll start to see some return to pricing power as excess capacity gets absorbed."

She expects the companies in her portfolio, which also includes China Telecom Corp. and PetroChina Co., both listed in Hong Kong, to post a 10% to 15% rise in net profit this year.

Ms. Cheong says that as managers of companies listed in China become more investor-focused and market-oriented, she'll start to buy shares, but only when valuations drop.

"There has been a lot of change in China in the last few years," she says. "There are increasingly more mainland companies that I feel comfortable investing in. The problem right now is valuations -- you're really paying through the nose."

Take Daqin Railway Co., a coal-transport company. It is well run and profitable, she says, but the shares trade at 23 times her estimate of 2007 earnings. A similar company in India, Container Corp. of India Ltd., trades at 18 times estimated 2007 earnings.

"We will not pay heaven for companies that meet our criteria," she says.

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