Macro Tsimmis

intelligently hedged investment

BUY iShares FTSE/Xinhua China 25 Index (FXI)

Posted by intelledgement on Tue, 02 Jan 07

We select all of our long picks with the expectation of holding for at least five years, barring some fundamental shift that changes the basic underlying conditions and we are really confident about them all…so it is really difficult to have a “favorite”, as we expect all of them will beat the market. However, if you pressed us against the wall, we would probably have to say that the pick that is likeliest to exhibit extreme performance is FXI.

The massive buildout currently underway in China – with entire cities being built from scratch—is by far the largest construction effort ever undertaken by humankind. How fitting that it is brought to you by the same folks who dreamed up and implemented the Great Wall. Unlike that project, however—which from the point of view of stimulating productive economic activity, pretty much hit a brick wall (unless you owned a quarry or made construction equipment)—the potential for wealth generation inherent in this buildout is sheerly incredible.

The achievements to date are incredible enough. China’s GDP is more than ten times what it was 30 years ago: a sustained compounded annual growth rate (CAGR) of 8.7%…10.5% in 2006. The growth in wealth has lowered the percentage of the population in poverty to 10%, and moved a majority of people off the farms—the percentage of Chinese who make their living from agriculture is down to an all-time historical low of 45%. China, which has long lead all nations in population but trailed badly in most other statistical categories for centuries, is now first in the world in current accounts surplus ($179B in 2006) and currency reserves (over $1 trillion)…and they became the second biggest economy in the world last year on a purchasing power parity basis.

Of course massive growth is massive change, and massive change is, ipso facto, disruptive. So there are, inherently, some massive-scale risks here. Will the growing disparity in wealth between city folk and peasants outstrip the growth of the overall pie to the point of societal upheaval? Will the corrupt Chinese political system’s limits to flexibility fail to react fast enough to a swiftly developing problem? Will the bad loans that the amateurs running the banking system made to state-owned businesses drag down too many banks? Will the rampant pollution issues and effects of global warming cripple the buildout? Will demographic issues (too many older Chineses supported by too few youngsters) hobble productivity? Will the imbalance of men (too many) and women (too few) lead the politicians towards militaristic adventures to distract folks from the other problems and bleed off the excess? Will a health wildcard (avian flu, AIDS which is not being managed well) cause problems?

No tree grows straight to the sky. Development in the USA, which was faster than that in Europe, also suffered from violent swings in business cycles…J.P. Morgan saved us from likely financial and potential socio-political ruin twice and then the Roosevelts did it again and again. So, while we expect that the waking of the Chinese dragon is the most signficant—and most lucrative—development of the early 21st Century, we anticipate some major down days along the road to Emerald City.

Furthermore, the Shanghai stock market, after years in the doldrums, was up over 100% in 2006 and the conventional wisdom is that a correction is overdue. Fundamentally, the iShares FXI ETF has no Shanghai market components—all 25 companies are mainland-based but tradeable on the Hong Kong market; about two-thirds are privately owned “H” class (which means the government authorizes them to list on the Hong Kong market) and one-third are government-owned “red chips.” FXI was up “only” 81% in 2006, and has a P/E of 19 and a yield of 1%…while not cheap, really not egregiously overpriced here given the growth potential.

We will hew to our risk management policy here…but if we get taken out of this investment (which we would consider doing with a 10% decline), we will most likely be back, once it is evident that the setback has run its course. Long term, you gotta be here.


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