China can crash – we’ll still make money in Asia

This time last year I wrote to you about the prospect of a severe crash in China. At the time I noted that a lot of people were urging investors to invest in China but that would be a terrible mistake, "because China is in the midst of a very painful episode in its history. The economy has recently slowed to its slowest pace in two and a half years. And that is likely to continue."

In hindsight, I wasn't far off. The Shanghai Composite Index has dropped 7.7% over the last year. And I can tell you that there is very little interest in the City for Chinese stocks right now. There are hardly any new Chinese funds being launched at the moment.

The reason for China's poor performance can be summarised with three words: policy driven market.

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Over 70% of China equity market earnings are regulated or managed by the government, according to Standard Chartered Bank. Furthermore, over 80% of Chinese stocks are state-owned enterprises, which are often forced to listen to the politicians rather than the minority shareholders.

I think you would have to be cracked to invest in China. And most British investors probably feel the same way. They are waiting for China to crash. And my hunch is that this turns a lot of people off the idea of investing in Southeast Asia.

I think that is a mistake. And I'd like to explain why today.

Beijing: just like the Kremlin

Most of the investment research you read on China is macro driven chiefly concerned with policy changes, economic data and what the political leadership and its affiliates are up to.

In truth Beijingology rules modern China, just as Kremlinology the study and analysis of the politics and policies of the Soviet Union dictated investment in Russia in the past. There is an awful lot of reading the tea leaves' and relying on titbits to figure out what is actually going on in China. In the Press Freedom Index 2013, China was ranked 173 out of 179 countries, only beaten by North Korea (178) in Asia. So this is no easy task.

Right now there is an intense debate going on over whether the new Chinese leadership will be able to implement a number of crucial reforms. The long-term game plan is spelled out in the World Bank China 2030 report which focus on six reform areas:

Implement structural reforms to strengthen the foundations for a market based economy

Accelerate the pace of innovation and create an open innovation system

Seize the opportunity to go green'

Expand opportunities and promote social security for all

Strengthen the fiscal system

Seek mutually beneficial relations with the world

These state reforms are bad news for investors

The key issue for China is reforming state-owned enterprises (SOEs). Bank of America Merrill Lynch calculates that SOE assets were equivalent to 154% of gross domestic product (GDP) in the first quarter of 2012, up from 147% at end of 2003. That is way above China's peers in the West, where the UK has about 5%, France 30% and Sweden 35%.

SOE-reforms are centred on reducing the power of licence-protected sectors such as banking, telecom and luxury consumption, and supporting private companies and SOEs in competitive sectors by improving management incentives.

But reform will be hard. BoA Merrill Lynch notes that previous SOE reforms were triggered by large SOE losses and laying off of SOE employees. The proposed current reforms will affect the powerful and well-connected which will make the likelihood of success much lower.

And even if they are successful, these reforms may not be reflected in the stock market. The last time reforms took place was in the late 1990s, when they helped to unlock huge productivity gains and fuel China's high-octane growth rate. But the snag was that it took the stock market more than five years before it moved sharply higher. The same could happen again, further aggravated by a West that is de-leveraging.

Where you'll really find the big gains

The recent economic data that is coming out from China suggests an economy that is plodding along. China's manufacturing Purchasing Manager Index (PMI) fell to 50.6 in April from 50.9 in March, which was slightly lower than market expectations of 50.7. As the leading indicator, new orders fell by 0.6 points to 51.7 in the month, showing that the pace of demand recovery remained sluggish.

The MSCI China trades on a price/earnings ratio of 8.9 times 2013 earnings, with growth in earnings per share of 11.7%. Hardly expensive, but keep in mind that the index is heavily skewed towards banks that might be in trouble.

Fitch downgraded China's long-term credit rating from AA- to A+, based on "underlying structural weaknesses" in the Chinese economy, warned of the growing risk of shadow banking and pointed out that total credit in China may have reached 198% of GDP by the end of 2012, up from 125% in 2008.

A year ago I wrote "Instead of a short and sharp crisis like in 1997, I envisage a prolonged downtrend like Japan as the financial system slowly digests poor loans and misallocation of capital." I still believe this is set to be China's fortunes.

But investment in Southeast Asia is another thing altogether. The stock markets in these regions are thriving. This year among all the Asia Pacific countries, the best performing markets are Laos 19.6%, Philippines 18.7%, Thailand 15.7% and Vietnam 13.3%. But that really doesn't tell the story of the tremendous investments you can find if you scratch the surface in this region.

I'm certainly not struggling to find bigger winners in my Profit Hunter portfolio right now you can find out more about these here.

But we've seen some strong performers in The New World too. For example, back in August last year I mentioned PTT Exploration and Production (PTTEP) and Italian-Thai Development (ITD TB) as great ways to play the Mekong boom. PTT has yet to make its move. But ITD has delivered a very nice 151% since then. And that is the kind of game that I am aiming for by investing in this story.

For me, the aim of investing in emerging markets is all about growth and finding stocks that are off the beaten track those that offer the potential for outsized returns for patient investors.

Investing in such stocks offers two potential benefits: direction (you are riding the uptrend) and convergence (over time, valuation catches up with larger peers if the fundamentals remain robust).

I believe that Southeast Asia will begin to converge with China.

In Southeast Asia today, they're still making the early investments. They're picking the low-hanging fruit, and boosting their economy significantly with each investment in rail networks, ports and transport hubs.

But they are also experiencing the early stages of a remarkable consumer boom. Among the industries that are already profiting are food and drink, clothes, vehicles and transport, and insurance.

That's why there is such huge investment pouring into this region right now. As I pointed out recently, US foreign direct investment (FDI) into ASEAN rose to $19.9bn in the first nine months of 2012, up 126% from the same period a year ago. Stronger percentage increases in US FDI were seen in Singapore (177%), Thailand (126%) and Indonesia (53%), according to Bank of America Merrill Lynch.

They are wise to be investing in this fast developing region as it frees itself from the influence of China and becomes an economic superpower in its own right.

This article is taken from The New World, MoneyWeek's FREE regular email of investment ideas and news from Asia and Latin America. Sign up to The New World here.