Outlook 2008: Eight Ways to Pocket Profits From China, While Dodging the Biggest Risks

Editor's Note: This is the Second Installment of an Ongoing Series Addressing the Outlook for Investment Opportunities and the Global Economy in 2008.

By Don Miller
Contributing Writer

Think the party's over in China?  Think again.  The "Next China" is ... China.

While some naysayers have pegged China as a bubble that's poised to pop at any moment, the long-term reality is that the Asian giant is poised to continue its remarkable run.

"Investors who know where to look are likely to see gains of 30% to 50% in the year ahead," says Keith Fitz-Gerald, investment director for Money Morning. "If you factor in the pent-up demand from Chinese investors who really want to be part of what's happening in their own country, you can see that kind of upside won't be out of the question."

While China is not the sole focus of our fundamental belief in the wisdom of global investing, its size and growth make it a perpetually key consideration. To understand just how big an investment opportunity the People's Republic of China represents, a side-by-side comparison with the U.S. economy is a worthwhile exercise.

Here is a current economic snapshot of the two markets:

Currency:  The greenback is a reflection of this country's economic soul.  During prosperous periods, global investors bid the dollar higher. When the outlook is dour, those investors run for cover.

Over the past year, thanks in part to the U.S. economy's towering twin deficits - budget and trade - investors have been voting with their feet, and the dollar has dropped to 30-year lows against most other key currencies. Recent interest rate cuts have made the dollar even less attractive to foreign investors, accelerating the plunge.

Meanwhile, the Chinese yuan has been on a tear, rising 10% since July 2005, when China ended the fixed-rate peg against the dollar - causing tremendous angst among U.S. leaders. Fueled by its massive trade surplus, China has amassed $1.4 trillion in foreign-currency reserves; that's capital it can use to finance its ongoing growth by acquiring needed technologies, natural-resource reserves, or deal making know-how.

Economic Momentum:  The subprime-mortgage crisis has burst the U.S. housing bubble. Consumer spending  - which accounts for as much as 70% of this nation's economic activity - has reached a worrisome stage. With predictions for fourth-quarter Gross Domestic Product (GDP) having fallen to 1%, recession predictions are escalating.

But while the United States struggles, China's economy continues to zoom. Experts estimate that China's economy advanced at a white-hot 11.9% in 2007. The market has advanced at a double-digit rate for each of the past four years, and most experts believe that 2008 will be no different.

One other factor in China's favor: Unlike the U.S. economy, which built a lot of its growth on the back of ultra-cheap capital spawned by the now-imploded subprime-debt bubble, China consumers are sitting on $2.2 trillion in personal savings and typically put down 80% when paying for a home.

And even a recent World Bank report that concluded that China's economy may be smaller than most economists believe ends on a bullish note: China's $5.33 trillion net worth is second only to the United States, with $12 trillion. And when measured in terms of purchasing power parity, China accounts for nearly 10% of global output - even though it's less than a tenth the size of the U.S. economy.

The bottom line: No matter how you measure it, China's economy leaves a lot of upside for investors to profit from.

Inflation: Oil has been hovering around the $100-a-barrel price level for months. In a report released last week, the U.S. government finally acknowledged the obvious: High gasoline prices are hitting us right in the wallet. Prices rose 0.8% last month, with $3 a gallon pump gasoline leading the way. Simultaneously, the Paris-based International Energy Agency, or IEA - advisor to 27 industrialized nations, including the United States - boosted its outlook for oil demand for the New Year. The IEA sees demand rising by 2.1 million barrels per day in 2008, an increase of 200,000 barrels per day from its previous forecast. The IEA has also warned of a "supply crunch" coming within the next five years.

Needless to say, energy prices are going nowhere but up, and that, in turn, will ratchet up the inflationary pressures across the board.

Needless to say, this puts the U.S. Federal Reserve in a bit of a box. Central bank policymakers have been reducing short-term interest rates to keep the U.S. economy humming along. But with inflationary pressures on the rise, and the greenback in decline, the Fed may find it increasingly difficult to be able to keep cutting interest rates.

[A sharply declining dollar can be inflationary itself, since that boosts the costs of imports, and since oil producers in the OPEC cartel will keep boosting the dollar-denominated price of petroleum crude to compensate for the slumping greenback].

Of course, inflationary pressures exist in China as well - strong ones, in fact. But remember, China is not a free-market economy like its U.S. counterpart. The government controls the prices of a vast array of items, especially politically sensitive ones like foodstuffs, fuel and other consumer goods. And the Communists are not afraid to act: Back in September, government leaders froze prices on some items for the rest of the year.

How to Play China in 2008

To understand just what's happening on the global-investing stage - including the steady deterioration of U.S. influence in worldwide markets - several factors are crucial to understand:

  • China is on the edge of an economic transformation known as "global decoupling," in which the U.S. economy is slowly being excised from its role as a global leader and economic trendsetter. This trend, which will continue for decades to come, means that the U.S. market will no longer be essential for global growth.
  • As is true of any nascent investment opportunity, the "early in" investors will reap the biggest rewards.

According to the McKinsey Global Institute, from 2005 to 2010 alone worldwide financial wealth will soar from $118 trillion to more than $200 trillion - with the newly capitalist markets of Asia and Europe accounting for the biggest portions of that increase.

Right now, the U.S. economy and that of Asia each account for about 28% of the global economy. But over the next 25 years, the United States will see its share of the global economic pie slip from the current 28% down to 24%.

At the same time, however, Asia's share will almost double - to 55% of the worldwide economy. And as its size grows, so will its political and financial influence.

But make no mistake: China does pose an investment risk. In the past year alone, China's markets have been several times been hit by double-digit corrections. The volatility will certainly continue. But faster-than-average growth will continue - in both the short-term and for the long haul, experts say.

By far the biggest investment risk is concentrated in China's mainland stock markets. And even the shares of China-based companies listed on the venerable New York Stock Exchange aren't entirely safe.

So how can you balance risk versus return?  By selecting global stocks that are riding the biggest consumer wave in history.  

China's middle class is 100 million strong and is expected to double in size by 2010.  Back in the halcyon 1980s, the United States had its "yuppies." And the China of today now has its "chuppies," - Chinese consumers who are well educated, who have good jobs - and who have cash that's burning a hole in their collective pockets.

Indeed, consumer spending is projected to reach $2.3 trillion this year [compare that to the much-larger U.S. economy, which is $13 trillion in size - with as much as $9.1 trillion accounted for by consumer spending]. Nike athletic shoes, thick steaks, jewelry, iPods and iPhones, GPS devices for cars, and all sorts of gadgets are flying off store shelves. Retail sales in China rose by 18% in October, and will rise by an average of 16% for all of 2007. It's the most explosive market in history and companies from every nation are racing to cash in.

The key to profiting from China, while also managing risk is to pick the foreign companies best positioned to capitalize on these trends. Among them:

  • Nokia Corp. (NOK), since 82% of China's urban dwellers use wireless phones.
  • Daimler AG (DAI) maker of Mercedes Benz cars and sport-utility vehicles, and Tiffany & Co. (TIF), since China will soon be the No. 1 market for luxury goods in the world.
  • Yum! Brands Inc. (YUM) and McDonald's Corp. (MCD), since China's consumers have developed a real penchant for American fast food.
  •  PepsiCo. Inc. (PEP) and The Coca-Cola Co. (KO), because China's consumer have become quite brand-conscious and want only the best.

Notice any commonalities?  These firms meet our key criteria of profiting "from" China without having to be based "in" China. They offer the built-in safety of globally diversified operations, while also having an extensive - and potentially profitable - exposure to China's burgeoning consumer market.

If you are more of a mutual-fund fan, there's one fund that is especially worth your consideration: The U.S. Global Investors Inc. (GROW) China Region Opportunity Fund (USCOX).

Put some holiday cheer - and some profits - in your investment portfolio by buying into some companies that are poised to profit from these trends.
Money Morning's Outlook 2008 Series Last Covered Oil Prices. Next Up: The U.S. Economy.

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