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An electronic board showing stock information is seen above investors at a brokerage house in Wuhan, Hubei province January 4, 2012. China shares started the new year weaker on Wednesday, dragged down by more cyclical sectors after the Chinese premier warned of difficult economic conditions in the first quarter, hinting there will not be another massive fiscal stimulus program. (Reuters)
An electronic board showing stock information is seen above investors at a brokerage house in Wuhan, Hubei province January 4, 2012. China shares started the new year weaker on Wednesday, dragged down by more cyclical sectors after the Chinese premier warned of difficult economic conditions in the first quarter, hinting there will not be another massive fiscal stimulus program. (Reuters)

Emerging MARKETS

The case for doubling down on China Add to ...

Burton Malkiel championed low-cost index investing before it became popular. Now, the Princeton University economist is pounding the table for Chinese stocks.

The 79-year-old academic is best known as the author of A Random Walk Down Wall Street, a classic explanation of why it’s fruitless for active investors to try to beat a passive market index. These days, however, he believes most investors – even those who hold broadly based global indexes – are being too passive when it comes to buying into China’s growth story.

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“In all of the times that I have studied China and the Chinese stock markets, there has never been a period where the valuation metrics are as favourable as they are today,” said Mr. Malkiel, who is also chief investment officer of U.S.-based Baochuan Capital Management LLC, which runs China-focused hedge funds using indexing principles.

“The price-to-earnings ratios is below 10,” he said in an interview. “Historically, we have seen Chinese stocks at 30, 40 and 50 times earnings.”

Fears of an economic slowdown have dragged down Chinese stocks over the past year, while allegations of fraud at many China-based companies have also poured cold water over the country’s stock market. But it has recently been rebounding on signs that Beijing will adopt policies to spur growth, such as its recent lowering of the amount of capital banks need to hold in reserves.

With Europe, its biggest export market, likely in recession, China’s growth is expected to slow from 10 per cent a year to below 8.5-per-cent, Mr. Malkiel said. But relative to the rest of the world, he said, “China looks even better to me than in the past.”

Mr. Malkiel says investors have a good chance of earning a double-digit annual return in Chinese stocks over five years, assuming an unpredictable event like Israel bombing Iran doesn’t sideswipe the global economy.

His upbeat view is in dramatic contrast to the picture painted by skeptics such as U.S. economist Nouriel Roubini, and hedge fund manager Jim Chanos who believe China’s economy is headed for a hard landing. The Chinese property bubble is “Dubai times 1000,” warns Mr. Chanos, an investor who foresaw the 2001 collapse of Enron Corp.

China’s estate prices have slipped 20 per cent, and will probably go down further, Mr. Malkiel acknowledges. However, he believes that tight lending requirements will prevent a collapse of the market. Chinese buyers need a 40-per-cent down payment for their first home, and a 60 per cent down payment to speculate on a second house, he said.

Even if some of China’s financial institutions run into trouble, the central government can bail them out, given that its debt to gross domestic product (GDP) is a mere 17 per cent, he said.

Mr. Malkiel made his name as a proponent of index investing, but he doesn’t believe that the popular indexes for global investing, which have about 2-per-cent exposure to China, do a good job of representing the country. “As an indexer, I think you need to have more China than you are going to get by simply buying the [U.S.-listed]anguard Total World Stock ETF,” said Mr. Malkiel, a former director of the Vanguard Group Inc.

The problem is that the Chinese A shares, which trade in Shanghai and Shenzhen, are not included in world indexes, he said. “Because the Chinese government owns a substantial part of the shares of banks, oil and telecom companies, those are considered control holdings, and are not included in the float.”

He co-founded AlphaShares LLC, a creator of China indexes, because he felt existing offerings, such as the popular FTSE/Xinhua China 25 Index, were not diversified enough. His firm licences indexes to exchange-traded fund (ETF) providers, including Claymore Investments Inc. in Canada.

So how much China exposure should investors have? “It ought to be at least 10 per cent,” he suggested. “That is the size of China in the world economy. I would probably want to see that increase over time because I think China is going to be a bigger economy than the United States by the end of this decade.”



China's giants

Top 10 Stocks In Alphashares' China All-Cap Index *

-Industrial & Commercial Bank of China

-CNOOC Ltd.

-China Construction Bank Corp.

-PetroChina Co. Ltd.

-Baidu.com

-China Mobile Ltd.

-Tencent Holdings Ltd.

-Bank of China Ltd.

-China Life Insurance Co.

-China Petroleum & Chemical Corp.

*Top holdings in Canadian-listed Claymore China ETF in Canada and U.S.-listed Guggenheim China All-Cap ETF. Both track AlphaShares China All-Cap Index

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