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Panic over SARS creates an opportunity
Chinese stocks have suffered since the outbreak of the deadly illness in Hong Kong, its trading gateway, but the country's fundamentals remain strong.
By Timothy Middleton
Fear of SARS is spreading around the world, but at its epicenter, Hong Kong, the new disease is causing outright terror. And health concerns are spilling over into financial markets.
There is pretty much a panic situation here in Hong Kong, says Mark Mobius, manager of two of the best-performing funds investing in the region. But the veteran investor knows what often comes with panic. I think it provides an opportunity, he says.
Since March 21, when severe acute respiratory syndrome became recognized as a global health threat, the Hang Seng Index has declined about 5% as of April 3. That brought the index to a year-to-date loss of nearly 8% and a retreat of 28% from last years May high.
Its easy to understand why Hong Kong investors are panicking. SARS, a virulent form of pneumonia, was unknown until last month, when it began to spread apparently from Chinas Guangdong province, which is adjacent to Hong Kong.
The lethal disease is so contagious that the World Health Organization has recommended travelers shun the region, all but isolating it from the rest of the world. Airlines, the most immediate corporate victims of the outbreak, have canceled hundreds of Hong Kong flights a week. Intel (INTC, news, msgs) canceled two Asian conferences. The economic impact on Hong Kong will be enormous.
The heart of the matter
But, in fact, the long-term fundamentals for China -- which is what you're targeting by way of its traditional gateway to the West -- remain strong. Chinas GDP grew 8% last year, when most of the world was in recession, and it is forecast to equal that this year.
What's the best way for investors to take advantage of this opportunity? By plunging into those China/Hong Kong stocks when everybody else is running away. And the best way to take advantage of single-country panic attacks is closed-end funds.
As China opened itself to the capitalist world, it did so by way of the former British colony it reabsorbed in 1997. China has two stock exchanges of its own, in Shanghai and Shenzhen, but they mainly represent second-tier -- or worse -- companies.
A lot of times these arent the best companies, says Yadong Liu, managing director of Medley Global Advisors in New York. A lot of them were not doing so well, and the government no longer wanted to subsidize them.
The best Chinese companies are listed on the Hong Kong Stock Exchange. Depending on their organizational structure, they are described as H shares or red chips. Also listed on that exchange are pan-Asian companies that investors describe as China plays.
The organizational chart
H shares are China-based companies whose shares are listed on the Hong Kong Stock Exchange. An example is China Petroleum & Chemical (SNP, news, msgs), the Beijing-based integrated oil giant that was formerly entirely owned by the state. Its revenue last year was $41.07 billion. (A handful of Chinese companies, including China Pete, list American Depositary Receipts on the New York Stock Exchange.)
Red chips are other premier Chinese companies that officially are headquartered in Hong Kong. An example is Denway Motors, whose car manufacturing facilities -- a venture with Japans Honda -- are located in Guangzhou (formerly Canton) in southern China.
China plays are companies with extensive operations outside China that are in a position to replicate them inside the country as its economy grows. An example, the largest holding of Templeton China World Fund (TCH) is Dairy Farm International Holdings. It operates supermarkets and other retail stores throughout Asia. It has 52,500 employees and had sales last year from continuing operations of $4 billion.
China World is managed by Mobius, the protg of legendary investor Sir John Templeton and the Westerner best-versed in the stocks of emerging-markets companies.
Reached by cell phone at his dinner table in Hong Kong, Mobius was upbeat about investments in China, even considering SARS.
A world away
I was just in China (two weeks ago) and I didnt see any concern whatsoever, he says. I get the feeling that in China youre not going to see the same level of concern you have in Hong Kong.
He believes the fear of SARS is worse than the disease itself, and that the kinds of companies in which he invests -- virtually all H shares and red chips -- have strong fundamentals amid one of the few buoyant economies in the world.
In addition to China World, Mobius also manages Templeton Dragon Fund (TDF).
Closed-end funds are fundamentally different than mutual funds. They have fixed assets, meaning they dont face redemptions, and they trade like stocks, mostly on the New York Stock Exchange.
But because they aren't exchangeable for cash, as mutual funds are, they are vulnerable to supply and demand. Unpopular closed-ends trade at a discount to their net asset value, and popular funds at premiums. Thats what leads them to become particularly attractive during panics.
Despite the success of some China funds -- Templeton Dragons net asset value spurted 14.2% in the 12 months ended Feb. 28 -- they continue to trade at discounts.
| China fund discounts from NAV* | | Fund | 1-year perf. | Discount | | Templeton China World (TCH) | 19.8% | - 3% | | Templeton Dragon (TDF) | 14.2 | - 10.8 | | China Fund (CHN) | 12.7 | - 1.7 | | Jardine Fleming China Region (JFC) | 2.4 | - 5.9 | | Greater China (GCH) | - 3.6 | - 12.2 |
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*Performance data are 12-month change in net asset value as of Feb. 28. Discounts from net asset value are as of April 2.
Source: Closed-end Fund Association
The Templeton funds are the subject of a battle between Templeton Asset Management and Harvard University, which is a major investor in them. The two sides have agreed that China World will convert to mutual-fund status, and its discount has declined to just 3% from an average over the last year of 10.3%.
Dragon will offer to redeem some of its shares, through the distribution of the underlying stocks to large shareholders. That doesn't amount to an offer to make such redemptions regularly, as so-called interval funds do, however, so its discount of 10.8% has declined only slightly from the 12-month average of 13%.
The lowdown
These forces slightly skew what is otherwise evident among the China funds -- the best ones have the lowest discounts. China Fund (CHN), which has spurted 12.7% in the 12 months ended Feb. 28, has the lowest discount in the group, of 1.7%. The fund with the biggest discount, Greater China (GCH), also has the worst record.
My personal pick among them, based both on Mobius' acknowledged supremacy as an emerging-markets analyst and the funds current discount, is Templeton Dragon.
Mobius is a tire-kicker. Seven years ago I lunched with the manager of a rival China fund, who was born in China, speaks Mandarin and visits the country frequently. I asked him if he was the first Western investor to visit backwoods Chinese companies.
No, he replied. They always tell me there was a short American with a bald head who had already visited them. Mobius is short, bald and famously well-traveled. Like other Templeton managers, he also prefers cheap, value equities over rich, story stocks.
Especially in emerging markets, story stocks tend to evaporate into thin air.
At the time of publication, Timothy Middleton didnt own any securities mentioned in this article.
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