Middle Age for the Middle Kingdom

Posted on: March 12, 2012 in: Economic Growth, Emerging Markets with 0 comments

GUGGENHEIM CHINA SMALL CAP ETF                       Ticker: HAO / NYSE

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China is aging and as it leaves its youthful days of high-energy growth behind, the middle kingdom will settle into a more genteel, more comfortable middle-aged existence. The implications for investors are many and require a re-think of your investment strategy.

Middle-age has been a few years coming but the joint pains were especially sharp this week. Speaking at the annual National People’s Congress meeting, Premier Wen Jiabao lowered China’s target growth rate and said it would gradually reduce its dependence on capital-intensive growth in favor of strengthening domestic consumer demand.

Markets reacted instantly. The Shanghai Shenzen 300 Index fell nearly 3% and the iShares FTSE China 25 Index ETF (FXI/NYSE) fell more than 6% on the announcement. But beyond the instant, is this policy shift really a bad thing? We don’t think so.

My vision of China, shaped by travels and by Edward Burtynsky’s horrifying photography, is one of dirty, heavy industry consuming mountains of resources – people, steel, oil – to produce cheap baubles for export to the world. To have this present give way to a kinder future would be wonderful.

Nor is the present model sustainable. The last decade of lopsided trade relations between China and the rest of the world were doomed to fail, especially with demand from China’s biggest customers, Europe and the United States, falling in recent times and austerity cuts as far as the horizon.

Then there are China’s internal pressures: Ethnic hatreds spark hinterland riots that are fed by idle poverty; Urban housing is in crisis, with a modest apartment in south China priced at about 45 times the average salary (they joke that a peasant would need to have worked from the end of the Tang Dynasty in 907 AD to afford a Beijing apartment today); iPad and Dell PC assemblers at Foxconn routinely use suicide as a bargaining chip. If China did nothing, how long would this pressure cooker remain intact?

Premier Wen confronted these tensions. He announced higher minimum wages in the big cities, a 20% increase in education, health and welfare spending, and allowing more rural folk to migrate to the cities. The boost in consumer spending from these changes will help offset the loss in demand elsewhere. He also committed to keeping a tight rein on property prices by controlling speculation and by building more public, subsidised housing.

The evolution underway in China is not unique. Early industrial England with its hellish factories and impoverished masses eventually emerged as a more diversified economy producing more wealth for more of its people. Could China achieve the same over the next decade? DDB, the ad agency behind Volkswagen’s cute-kid-as-Darth-Vader ad, thinks so. It is moving its creative office to China.

What about for investors? China will still have heavy industries but demand for their outputs will fall over several years. And the export-oriented factories churning out everything from telephones to teddy bears will need to target domestic consumers. Consumer-oriented sectors will benefit: Retailers; makers of refrigerators, cars and other durables; health-care and pharmaceuticals.

There are several China ETFs available but few reflect this future China. The biggest ETF is the iShares FXI, with about $7 billion in assets, holding 26 large cap stocks with market caps of near $100 billion. More than half the ETF by weight is in financials and real estate – two areas of the Chinese market that are best avoided right now. Another 30% is in other large energy, mining and industrial firms.

For a more Chinese consumer-oriented ETF, consider instead the Guggenheim China Small Cap ETF (HAO/NYSE). It holds 230 companies and a quarter of its allocation is to firms like retailers, hotels, and food and beer makers. Another quarter is in industrial firms making trains, planes and automobiles. Its exposure to banks and real estate is a tolerable 16%. Overall, HAO offers a more diverse slice of the Chinese economy and especially the parts that will benefit from a stronger consumer. Other metrics – dividend yield, price-to-earnings and returns – are also positive compared to FXI and others.

Aging is rarely pleasant but with an ETF like HAO, it can at least be somewhat profitable.

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Chart courtesy of Bloomberg L.P. Click on Chart for Larger Image

archerETF Metrix 09 Mar 2012
Ticker/Exchange HAO / NYSE
Name GUGGENHEIM CHINA SMALL CAP E
Categories Equity / Asia Pacific / Multi-cap
Total Holdings 230
52 Week High 31.03
Recent Price 23.4
52 Week Low 16.65
Avg Daily Volume 97,429 shares
Avg Daily Volume ($) $ 2.3 Million
Total ETF Assets $ 179.0 Million
Allocation to 10 Largest Holdings 12.09%
ETF Annual Fee .75%
ETF Trading Currency USD
ETF FX Exposure Chinese RMB
Annual Volatility 30.41%
Correlation to S&P TSX Comp. 71.10%
Return to Risk Ratio -0.14
Beta to S&P TSX Comp. 1.21
Price-to-Earnings Ratio 15.15
Use of Leverage No
Use of Futures No
6 month Return 8.58%
1 Year Return -17.73%
3 Year Return 28.65%
Dividend Yield (TTM) 2.65%

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© 2012 archerETF Portfolio Management is a division of Bellwether Investment Management, a discretionary portfolio manager registered with the Ontario Securities Commission. This report is provided for information only and does not constitute investment advice. While we believe the information to be accurate and timely, we make no claim or warranty to that effect. Please seek professional advice before making any investment decision. We may hold positions in any or all securities discussed in this report.

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