Invest in China's Consumer Sector, Not Banking

NEW YORK (TheStreet) -- Investors should be looking past the banking sector to the consumer sector in China, with ETFs such as Claymore/AlphaShares China Small Cap and Global X China Consumer.

The Agricultural Bank of China's IPO is grabbing headlines, but the big news for AgChina has drowned out more negative news for the banking sector. China's government used the banking sector to implement much of its stimulus policy in 2008 and 2009. Banks jumped at the chance to make loans and there's liable to be some amount of bad loans in the mix.

Even before these bad loans have emerged, the banks need to raise capital to shore up their balance sheets amid tightening regulations in China. One such regulation passed just this week reduces the amount of loans that banks can package and sell to financial companies. This means the banks will have to hold more assets on their balance sheet and will have to slow their lending growth.

Last week, Bank of China said it will raise nearly $9 billion in a rights offering, close to half of the total that AgChina hopes to raise in its IPO. The other large banks in China are in similar positions and will also need to raise capital.

The issuance of shares dilutes existing shareholders and the iShares FTSE/Xinhua China 25 has more than 45% of assets in the financial sector, with more than half of those assets in big state owned banks.

The rest of the FXI portfolio is also heavy in state-owned industries, especially telecom, energy and basic materials. These companies are less efficiently run than the private sector of the economy. Some investors like the idea of having the Chinese government stand behind their investments, but as the telecom restructuring showed, these companies may also be more tightly regulated, especially those in consumer sensitive areas.

For instance, China recently capped coal prices to fight inflation, but prices are still rising and that means domestic coal producers will miss out on profits. Just like in the United States, rising gasoline, electricity, and phone bills spark consumer anger. The companies providing consumer needs are going to face tougher regulations than the companies that produce consumer wants, as the government comes down on the side of social harmony over corporate profits.

ETFs such as HAO and CHIQ face much less of a problem. While they still have exposure to state-run firms, many of the companies in their portfolio are in consumer and technology sectors that have less stringent supervision.

Chinese consumers are also seeing their wages increase. Strikes at several foreign automakers generated international headlines, but walkouts have occurred at other firms across the country. In response, the government is moving proactively to raise wages.

In the past month, several provinces have hiked their minimum wage, with the industrial powerhouse of Guangdong raising it more than 20%, and Henan province hiking it 33%. Henan's 600 yuan minimum wage is still less than $100 a month, but the wages are moving higher all over the country in the wake of strikes.

Foxconn, a major supplier to electronics companies and mobile handset manufacturers such as Apple, is also moving some of its factories from Shenzhen (where the minimum wage is 1,100 yuan per month) to Henan in order to take advantage of lower wages. This trend will be in effect for years as the wealthier coastal provinces move up the economic ladder and the lower wage industries move inland.

With its heavier focus on consumers and private industry, HAO is a good choice for a broad China ETF. There's a bit more risk than FXI in terms of volatility, but with the largest sector, industrials, at only 30% of assets, there's much less sector concentration. It also has more assets allocated to information technology, plus 20% assets split between the consumer discretionary and consumer staples sectors.

As a pure play on the consumer, however, investors should turn to CHIQ. This fund's top holding is Want Want China, at 5.7% of assets. Want Want China is the Chinese division of the Taiwanese company of the same name and its products are ubiquitous in supermarkets and convenience stores in China. Hefty exposure to consumer staples also comes from meat processor China Yurun Food and instant noodle maker Tingyi. At more than 5% of assets are Parkson Retail and China Resources Enterprise, which deliver retail exposure.

Due to its focus on consumer stocks, CHIQ also has large exposure to automotive, pharmaceutical and athletic footwear and apparel.

The fund has attracted investor attention and average daily volume is healthy, albeit due to sporadic burst of trading. Volume is low to moderate, with 50,000 shares or less traded on many days, but occasionally spiking to more than 100,000 or 200,000 shares per day. I'd like to see volume more consistently high, but investors looking for a long-term holding rather than a trading play can add small positions.

China's government is moving ahead with currency reform and allowing the yuan to appreciate. A stronger currency should make imports less expensive and will benefit Chinese consumers, especially since they are also seeing their wages increase. The government is committed to building a middle class and tax reform is one area being looked at to foster this policy. On the other side, the financial and property sectors are facing limits to growth and some state-owned companies are being managed for the benefit of the Chinese consumers, rather than the shareholders.

Therefore, the prudent play is to follow the government reform efforts and invest broadly with HAO, or targeted with CHIQ, while avoiding the financially and state-owned-enterprise heavy FXI.


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