The new China syndrome is soaring stock prices

Recent recalls of Chinese products, including poisonous pet food and toys coated in lead paint, are having little effect on red-hot Chinese stocks.
A look at one of the most popular exchange traded funds following an index of such stocks tells the story.
The $6.31 billion iShares FTSE/Xinhua China 25 Index Fund from Barclays Global Investors of San Francisco was up 37.89% year-to-date as of last Thursday, and had a one-year return of 94.23%.
That compares favorably with the $18.19 billion iShares MSCI Emerging Markets Index Fund, which follows a much broader index of emerging-market stocks. It was up 19.39% year-to-date for the same period, and had a one-year return of 43.05%.
And iShares’ Chinese ETF blows away the Standard & Poor’s 500 stock index.
The index was up 4.6% year-to-date as of last Thursday, and had a one-year return of 12.7%.
Looking good
ETFs and mutual funds that invest in such stocks look very attractive — especially the handful of actively managed China mutual funds.
For example, the $222 million AIM China Fund from AIM Investments of Houston, a subsidiary of Atlanta-based Invesco PLC, was the top performing mutual fund year-to-date as of Thursday, with a return of 64.7%. Its one-year return of 124.17% also led all others. Year-to-date, the top five overall were China funds.
Some China fund managers said they expect the good times to keep on rolling — albeit at a slower pace.
“We believe that the compelling case for investing in Chinese equities remains intact, based on very sound medium- to long-term fundamentals,” said Samantha Ho, investment director of Invesco Hong Kong Ltd. and manager of the AIM China Fund.
Even if that’s true, however, financial advisers said Chinese funds make them a little nervous.
They can be good for an investor with a little extra money to play with who has a high risk tolerance, said Scott Kays, president of Kays Financial Advisory Corp. in Atlanta. But given the recent run-up in Chinese stocks, he said, he’s not even sure this is the right time for those investors to consider such funds.
“You have to look at the valuation of the stock market,” Mr. Kays said.
And in his opinion, valuations are just too high.
That’s understandable, considering that back in June, Wachovia Securities LLC of Richmond, Va., was reporting that shares on the Shanghai Stock Exchange were trading at an average price-earnings ratio of about 50, while stocks in the S&P 500 were trading at an average p/e of 18.
Valuations for many Chinese stocks are on the high side, said Edmund Harriss, London-based manager of the $200 million Guinness Atkinson China & Hong Kong Fund, offered by Guinness Atkinson Asset Management Inc. of Woodland Hills, Calif.
His was the fifth-best-performing mutual fund year-to-date as of last Thursday, with a return of 51.44%. It had a one-year return of 85.21%.
Not all Chinese stocks, however, are overvalued, Mr. Harriss said.
Lower valuations can be found among basic-materials companies, he said.
For example, Mr. Harriss is a big believer in companies such as PetroChina Co. Ltd. of Beijing, which produces two-thirds of China’s oil and gas; Anshan Iron and Steel Group Corp. of Anshan, one of China’s largest producers of steel and metal products; and Yanzhou Coal Mining Co. Ltd. of Zoucheng, a leader in coal production in eastern China.
Such companies are “plays on Chinese growth and domestic investment,” he said.
Ms. Ho has a similar outlook. A trend toward urbanization will benefit companies involved in infrastructure, she said, but increased wealth among the Chinese will benefit other kinds of companies, as well.
“Our investment themes for China include consumption, infrastructure, financials, health care, environmental, as well as upstream sectors,” Ms. Ho said.
Both she and Mr. Harriss said they did not expect to see much fallout from recent scandals concerning tainted Chinese goods.
“It is worth noting that the manufacturers that produced defective toys are those that are in the low-end manufacturing sector,” Ms. Ho said. “For the AIM China Fund, we focus on higher-end manufacturers that bring added value to the products.”
It’s an emotional issue that gives China a black eye, Mr. Harriss said. But given the amount of investment flowing into China, he said, the scandals will have little effect on Chinese stocks.
In the end, it could be a positive, forcing China to modernize further, said Richard Gao, manager of the $1.7 billion Matthews China Fund, offered by Matthews International Capital Management LLC of San Francisco.
His was the fourth-best-performing fund overall year-to-date as of last Thursday, with a return of 53.44%. It had a one-year return of 101.2%.
Expects a correction
Despite his outlook concerning the recent scandals, however, Mr. Gao is not as optimistic as his fellow portfolio managers that Chinese stocks will continue to outperform for long.
Valuations are just too high to be sustained, he said. As a result, a correction is likely, Mr. Gao said.
Because of strong fundamentals, however, China is still a good long-term play, he said.
But even if the long-term prospects for China continue to look good, some financial advisers said, they are still leery of funds that invest only in China.
While Nicholas Spagnoletti, a partner with MACRO Consulting Group LLC in Parsippany, N.J., doesn’t have anything against China, he feels that decisions regarding exposure to specific countries are best left to portfolio managers of more diversified funds who understand those countries.
David Hoffman can be reached at [email protected].