DAVID STEVENSON: THE CHINA SYNDROME

By David Stevenson 2010-02-23
http://www.ftchinese.com/story/001031398/en
Anthony Bolton's epic move east to manage a new investment trust focused on China has prompted much excitement and even more pontification. Much of the debate has centred on whether China is destined to become the great economic superpower – or whether China is, in fact, only two steps away from political collapse (the argument advanced by George Friedman in his wonderful US bestseller The Next 100 Years).

I'm not going to bore you with my bearish views on the subject. Instead, I'd simply repeat the observations of independent economist Andrew Smithers. In his latest paper, he noted: “It is often assumed, or implied in circulars from investment banks and in articles in the financial press, that equity returns in rapidly growing economies should be higher than those in mature economies. Investors are therefore often encouraged to overweight their portfolios to favour shareholding in emerging markets. This is without theoretical justification, which points to expected returns in all stock markets being the same.” Notwithstanding Smithers' admirable fidelity to the facts, I would argue that there is a case for buying exposure to a big story such as China. However, the fund you buy into has to have a better rationale than “buy me because I buy Chinese shares”.

If I was forced to summarise my position, I'd accept the need to buy some exposure to China (albeit less than most would maintain) but only when prices were much, much cheaper. If prices were cheaper now – and sadly, they have been heading in the opposite direction – I'd perhaps be happy to buy a successful, mainstream fund such as JP Morgan's China investment trust. Or if I were being more adventurous, I'd look at buying into something trading at a chunky discount to net asset value (NAV), to give a margin of safety, or some special focus that offers a degree of protection. London-listed Vision Opportunity China (ticker: VOC) potentially offers both.

VOC is run by a small hedge fund management firm based in New York that stumbled on China almost by accident. Its specialism is tracking down sub-$50m small-cap growth stocks at a half-decent price which, over time, has led its analysts to focus almost exclusively on smaller Chinese companies. This keeps VOC away from all the $100m-plus deals beloved of the big investment banks and private-equity funds, who consider researching smaller companies uneconomic.

And VOC has one crucial advantage: it buys into unlisted companies that want to position themselves for an initial public offering (IPO) in the US (on Nasdaq or Amex) in the not too distant future.

That need to get western shareholders on board focuses the mind of the Chinese managers who are keen to have a foreign listing so that they can raise more capital and build an international profile. According to VOC's managers, that means it can buy into companies at between 4 and 10 times earnings and then sell out at between 17 and 25 times earnings when the company gets a US listing. Their claim has been supported by recent strong NAV growth at a rate outstripping any benchmark.

Now, I'm not going to pretend that this isn't a high-risk approach. Tiny investee companies can grow fast but they can easily become the victim of negative sentiment – so a sudden China bear market could spell disaster.

But it is possible to buy into the fund at a near 25 per cent discount to NAV (current share price is at around $1.77 vs NAV of $2.29) and the fund's managers have been marketing to new investors, which could prompt a narrowing of that discount (helped by some very positive reports from house broker Canaccord).