China Power Play

When a manager of the ( ICHKX) Guinness Atkinson China & Hong Kong Fund recently wanted to gauge China's infrastructure first hand, he hit the open road. Tim Guinness rented a car in Hong Kong, headed to the mainland and drove all the way north to Beijing. His conclusion: road tripping in China was surprisingly easy, with decent-quality highways and little bureaucracy. That finding helps explain his fund's heavy exposure to mainland energy plays. Over the long term, Guinness and fellow portfolio manager Edmund Harriss believe oil stocks should benefit as an expanding population of car owners heads to gas stations throughout China.

TheStreet.com spoke with China & Hong Kong fund lead manager Harriss about his taste for energy and commodity plays, and why he thinks the Chinese economy can avoid the hard landing some market watchers were predicting a year or two ago. The 12-year-old Guinness Atkinson fund has gained 12% year to date. Over the past decade, it's averaged a 6.35% return before taxes, compared to 7.40% for the Hang Seng Index and 9.06% for the S&P. It invests primarily in securities traded on the Hong Kong and Chinese exchanges (in the U.S., some of these shares only trade on the pink sheets).

TheStreet.com: What are your thoughts on the recent equities selloff that's hit Chinese, as well as U.S. shares, since mid-May? Why do you think it's happened, and will the selling continue?

Harriss: I don't believe yet that we're going to see any particular sort of adjustment in forecast earnings. I think the risks have certainly become more apparent. If the U.S. consumer hits the skids, is that going to drag down China's export growth? China's exports are not the most important part of its economy, but they are important. So you would find that certain sectors, certainly manufacturing and exports, would suffer.

On the other hand, I find that China's domestic economy has sufficient strength and firepower and availability of investment to keep powering ahead. There's a growing consumer market and a drive toward opening up the internal provinces that improves productivity, and that will give China some support.

I'm confident that China is a good place to invest, and there are good value stocks to be had. I'm not expecting a major selloff from here.

Have you added to your holdings as valuations have dropped?

I'm comfortable with the portfolio I have. I'm not making any major changes to it.

You also wrote that you expect '06 to be bullish for commodities like fuels, materials and metals.

I like to buy things China is short of, and commodities are one of those things. So, I have commodity stocks like Jiangxi Copper. Copper is used heavily in construction and infrastructure, in power transmission. And China is still growing its power transmission network substantially, so they're a huge user of copper.

In resources, I like the oils and have stuck with Yanzhou Coal ( YZC) because it's much cheaper than Shenhua Coal.

And also the steel company Angang New Steel ( ANGGF); it's an integrated producer and has access to iron ore through its parent company, which accounts for about 80% of its needs. I think its reorganization and the integrated nature of its business will help improve margins and the valuation of that company.

Your top 10 holdings are weighted toward the big Chinese energy players.

The oil story plays out as Chinese consumers discover driving. Clearly the long-term story in China is that as people become more affluent, they'll buy cars. The roads are excellent; it's very easy to get about.

China National Offshore Oil Corp. subsidiary CNOOC ( CEO) is an interesting one because of its terms of operation in home waters, whereby they get a slug of anything found, and other partners seem to do the work.

China National Petroleum Corp. subsidiary CNPC's ( CKKHF) assets are oil fields and oil reserves in Kazakhstan which they bought staggeringly cheaply, and yet the reserves there look pretty substantial.

How do valuations look for the oil companies?

I think that Petrochina is possibly starting to look quite fully valued. Petrochina is 11.6 times P/E for 2005 earnings. But Royal Dutch ( RDS-A) is on 8.3 times, Chevron ( CVX) 9.1 times, ConocoPhillips ( COP) on 6.6 times. CNOOC is on 9.9 times. So, Petrochina is looking relatively expensive.

The Chinese energy stocks are at the higher end on valuation. To justify that, you have to look at scarcity value, at the choices within Asia. You have to believe that Chinese growth is going to justify a higher rating, and also that maybe they can do deals others cannot to expand their reserves.

Since the government regulates oil prices, to what extent do domestic energy players benefit from the high price of oil on the world market?

They don't actually sell to consumers at world prices. They don't follow market prices exactly, and they do so with a lag, but they have a certain benefit from the run-up in oil prices.

What do you think about consumer plays in China?

For the most part, they're pretty expensive. They tend to be smaller-cap companies and businesses, and they trade on very punchy price-to-earnings ratios, so I find them a little bit difficult to swallow.

Take Wumart, the mainland supermarket -- I've never failed to be impressed by the people I've met there, the operation of the stores, their merchandising analysis. It's very professional. But, my word, is it expensive, and not terribly liquid. So I find it quite difficult to say I will buy this stock.

Moving to the economy, you wrote in a commentary in March, "The hard landing that many forecasters were calling for never happened" and that this year the prospect of a serious economic slowdown in China seems remote. Why do you think so, and what's changed?

There was a feeling through 2004 and into part of 2005 that a hard landing could happen. It was certainly being treated as such in many I-bankers' reports, as well as press reports. But around the end of last year and into this year, there's been a bit of a volte face; it's no longer expected that things are going to crash.

My basic view is that we have, at the moment, a comparatively short-term issue where growth is too fast and is becoming concentrated in certain areas, making authorities uncomfortable.

They wish to deal with that pre-emptively, but are still looking to maintain domestic economic growth. That is what creates jobs, improves standards of living, maintains social order. By maintaining the profitability of the industrial sector, that gives the government its revenues. And now for the first time, they're talking about increasing spending in rural areas, and they've finally got some money to do it. So, rhetoric can be matched by action.

What do you think are the risks in China?

There are plenty of risks you can point to. It's a very large economy that doesn't work particularly efficiently. It's growing very fast, and in that, sort of environment bottlenecks can occur.

The main problem in China appears to me to be excessive liquidity from an enormous trade surplus. And China has that because exports are growing strongly and imports are still lagging. They're growing, but they're lagging because of a cyclical issue in 2003/2004.

There was a boom period in 2002/2003 where credit growth went through the roof and a lot of investment went into steel, aluminum, autos, cement. In 2004, there were quite aggressive government moves to stop lending to those sectors. As a result of the buildup, there was excessive capacity and margins came down. Now infrastructure building is picking up and absorbing the excess capacity.

As the economy grows, that capacity will be absorbed, and China will find it once again turns into a net importer, which will cause the trade surplus to decline. So, the economy is already in the process of righting itself.

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