Recently announced reforms by China’s president in early November as part of the government’s long-term strategic plan, known as the Third Plenum, to open the country’s banking, energy and other key sectors to foreign investment may represent the most momentous change in the expansion of China’s markets since liberalization began decades ago.

Attractive investment opportunities will arise if these reforms are effective. As we’ve frequently noted, international investments such as emerging markets can offer diversification and wealth preservation against inflation.

And China’s leaders couldn’t be more explicit in their intentions. In a statement issued after a closed-door summit, they promised the free market would play a bigger role. “The core issue is to straighten out the relationship between government and the market, allowing the market to play a decisive role in allocating resources and improving the government’s role,” the statement said.

Many investors are understandably hesitant to pile back into countries such as China, after emerging markets’ stomach churning, wild ride over the last year, in large part driven by the Chinese economy’s slowdown and fears that the nation was headed for a hard landing (see chart below), even though the indices are up 18.99 percent.

Moreover, there haven’t been clear fundamental growth drivers to point to since China’s economy started to slow below 7 percent gross domestic product (GDP) growth. Various market sectors in China have been overheating, such as collapsing real estate markets and a banking sector that has been increasingly burdened by bad loans.

Exacerbating these problems are continued corruption, intellectual property issues and overall government interference in markets. And it should be noted that it could take years before these new market reforms are fully disseminated throughout the larger economy, and many economists predict the country’s growth will remain slow (6 percent to 7 percent) for the next few years.

But making money in China is contingent on your investment time horizon, and being at the right place at the right time. This means staying in for the long haul and understanding that the market will continue to develop, albeit in fits and starts. Patience is the key.

This was the view of many in-country chief executives of Western multinationals and conglomerates that your correspondent met in Shanghai, China in 2010 as part of my graduate business study at Oxford University. Even a few years ago, these divisional CEOs viewed the potential growth in China too great to ignore, despite a business environment that is largely opaque and has sometimes even been hostile to multinational companies.

China is on the Upswing after a Period of High Volatility

 

Source: YCharts

Keep in mind, the sales of one successful product in China can sometimes equal or exceed what’s reaped for that same product in the rest of the world combined, given the purchasing power of 1.3 billion people whose disposable income has been steadily increasing. China is the ultimate growth market for multinational businesses for the next 100 years and beyond.

Creating More Consumers

In addition to easing pricing rules in key areas such as the resource and finance sectors, China plans to loosen restrictions on the country’s one-child policy. The country is also moving hundreds of millions of rural Chinese into cities over the next decade, a key policy expected to help spur domestic demand. This is part of China’s long stated core strategy to reduce the country’s reliance on exports.

A model that relies less on exports and more on domestic consumption gives small- and medium-sized businesses more room, and allows the market to play a bigger role in the traditionally state-controlled economy.

Other key policy changes include a reformation of the welfare system. Under current rule, Chinese laborers who move to urban areas are required to give up public services to which they were previously entitled. Easing these rules will encourage more migration to factories where there is a labor shortage. Farmers will now be able to transfer and leverage land as collateral.

Previously, the Chinese government owned all land and farmers were only permitted to work certain areas of soil. This change is intended to spur further urbanization and investment.

Other reforms include setting up deposit insurance to encourage banking, market-based interest rates, fixing the Chinese initial public offering (IPO) system, and requiring state-owned enterprises to pay larger government dividends.

Investors enjoy a multitude of ways to play these trends. Notably, they can:

1) Invest in multinationals already doing business in China that will benefit from greater demand for their products;

2) Invest directly in Chinese state-owned enterprises (SOE) that will allow equity investments for the first time; or

3) Identify those leading Chinese companies that can use increased domestic demand as a launching platform to become global players.

The Commanding Heights

Even though investing in SOEs could be a new and promising opportunity, at present no one believes that the government will relinquish complete control of all these businesses. In most cases, the government will likely be a majority shareholder or partner.

Moreover, the reason China is seeking outside investment is in the hopes that this will create more transparency and innovation within these state firms (some are hopelessly inefficient). Consequently, investors should be very selective with respect to SOEs when the opportunity arises.

SOE profitability took a hit earlier this year. In the first quarter of 2013, SOEs reported 5.3 percent growth, compared to 2012’s first quarter growth of 7.7 percent. According to China Enterprise Research Institute researcher Li Jin, slower growth is attributable to “overcapacity, inefficient cost control, and slow industrial upgrading.”

As for the types of SOEs that recorded slower growth, Li identifies them as “mainly in the traditional industries instead of high-tech or emerging industries [that] rely largely on expanding investment to boost growth.” Overall SOE profits are largely supported by just a few massive, monopolistic SOEs.

Most SOEs are controlled by local governments, although it is those in the care of the central government that receive the most attention. Among the latter, there are three categories: those controlled by the State-Owned Assets Supervision and Administration Committee (SASAC); banking and finance organizations; and media, publications, culture and entertainment companies administered by government agencies. At the end of 2011, there were 144,700 state-owned enterprises, according to Chinese press reports.

It should always be remembered that the Chinese state remains at present a quintessentially Leninist regime, securely in control of the “commanding heights” of the economy, as best described in a Foreign Policy magazine article entitled, “The Dark Side of China’s Rise.” The insightful article, written by China scholar Minxin Pei, noted:

“[China] is either a monopolist or a dominant player in the most important sectors…It protects its monopoly profits in these sectors by blocking private domestic firms and foreign companies from entering the market [although in a few sectors there is competition among state firms].”

Writing in 2006, Pei, one of the world’s foremost experts on governance in the People’s Republic of China, added, “The government maintains tight control over most investment projects through the power to issue long-term bank credit and grant land-use rights.”

So, while investing in SOEs is a great opportunity, investors should never forget that the Chinese government will always cling to control and seek to protect the most valuable parts of the economy.

Assets of the 112 largest SOEs totaled $7.35 trillion dollars at the end of 2012; private investors will be able to take over 10 percent to 15 percent of an SOE’s equity. Chinese officials have said that some SOEs might be too large for any one investor fund group and will likely require diversified ownership.

For example, China’s five largest banks alone accounted for 35 percent of the profits of the country’s 500 biggest companies last year, according to data from the Chinese Enterprise Confederation. But even as investors have begun eyeing state banking assets, privately held companies in China have also applied for banking licenses and could also be a source for investment.

To capitalize on China’s new reforms, we advise investors to first look at Western multinationals because they are already doing business in China and are typically very liquid investments. Also consider private Chinese firms that are likely better run than state-owned enterprises. And finally, when they become available, consider investments in SOEs that are in key sectors such as banking and energy.

Despite concerns over whether China will be able to maintain steady growth, in the final analysis China offers a growth rate that’s presently higher than most developed countries. Moreover, a key inflation-fighting tool is diversification, and investing in China is a proven way to hedge your investment bets.

Solid China Plays Now

As mentioned above, to play China as an inflation hedge and overall growth investment, we recommend either Western multinationals or private Chinese companies.

While it is not possible to segment an investment in most Western multinationals by country, an investment in the holding company that owns businesses in various regions has many benefits. We have targeted companies whose potential growth in China-based operations is substantial enough to drive revenues and earnings while offering the benefit of global diversification.

Many firms have located in China with the anticipation that one day the financial sector would be liberalized, whereby the average Chinese citizen would have pension investments similar to those in the Western world. Today, Chinese citizens largely invest in real estate to preserve wealth, given the dearth of income investment options.

Your correspondent had the opportunity to meet with the in-country CEO of State Street (NYSE: STT) in 2010 and tour its operations in China. The Boston-based financial holding company was clearly getting ready for this day (the announcement of reforms) and advising the Chinese government on what would be needed to create a well-functioning asset management industry.

On Nov. 21, according to press reports, State Street announced plans to set up a fund-management company in China by establishing a joint venture with a Chinese trust firm. Jingwei Textile Machinery Co. said in a filing with the Shenzhen Stock Exchange that its unit Zhongrong International Trust Co. has agreed to set up the Beijing-based joint venture with State Street’s Hong Kong unit.

The new company will have registered capital of 300 million yuan ($47.7 million). Zhongrong will hold 51 percent of the joint venture, with State Street owning the rest, the filing said. The arrangement will need to be approved by China’s securities regulator, according to the filing. China has 73 fund-management companies, and more than half of them are joint ventures between local and foreign companies.

Meanwhile, State Street provides a host of financial services, including fund accounting, custody, investment management, securities lending, transfer agency services, hedge fund services and operations outsourcing for investment managers.

As an investment, the bank has outperformed, earning a total return that’s up 61.89 percent over the last year as compared to the S&P 500’s total return of 32.25 percent. It’s also delivered a 10.21 percent return on equity and pays a modest dividend of 1.44 percent, though with a payout ratio of 23.72 percent there’s plenty of room for the dividend to grow. In its last quarterly earnings call, State Street’s revenue of $2.56 billion was slightly ahead of the $2.54 billion projected by the analyst community and its adjusted operating earnings per share (EPS) of $1.24 beat the average analyst estimate by $0.05.

State Street is a buy up to 75.

Baidu (NASDAQ: BIDU), the Chinese-language Internet search provider, known as the Google of China, is sufficiently diversified to benefit in a number of ways from further liberalization in China’s economy. As the number of computers and smartphone users has grown in China, this firm’s advertising revenue from regular and mobile search stands to grow, in addition to revenue as an app distributor and as a mobile gaming operator, to name a few.

Baidu’s market share in China search is currently 63 percent. Its online marketing customers consist of small and medium enterprises (SMEs) throughout China, domestic corporations and Chinese divisions or subsidiaries of multinational corporations.

The company’s mobile segment is a strong catalyst for future growth, as mobile search traffic becomes more popular. Mobile search traffic grew at a 94 percent rate in 2012, compared to a 20 percent decline in PC search traffic for the same period. Smartphone subscriptions are expected to grow at a higher rate than total mobile subscriptions, fueled by the introduction of LTE service by the end of the year. At a 100 percent growth rate from 2012 to 2013 and another 50 percent expected growth rate through 2014 for smartphone subscriptions, mobile Internet offers Baidu a high growth track.

As an investment, Baidu has produced a whopping 39.73 percent return on equity over the past year, growth in revenue (year-on-year) of 47 percent, and a gross profit margin of 65.37 percent. Not to mention, the firm earned a net income for the year of $1.6 billion. These robust numbers could reflect the beginning of a substantive growth trajectory as a result of China’s recently announced reforms. Baidu is a buy up to 160.

To make a broad, diversified investment in the Chinese market, consider the iShares MSCI China Index Exchange Traded Fund (NYSE: MCHI).

The MSCI China Index captures large and middle cap representation across China. Top holdings include these giants: telecom China Mobile (NYSE: CHL), China Construction Bank Corp (HKSE: 0939), PetroChina (NYSE: PTR), and China Life Insurance (NYSE: LFC). These firms make up the aforementioned “commanding heights” of the Chinese economy, which will be open for greater investment and could potentially provide a future source of outsized growth.

The iShares MSCI China Index ETF is a buy up to 55.

For portfolio updates, see this week’s issue of Inflation Survival Letter.