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China's growth is certain, but will investors benefit?

Dan Richards is president of Strategic Imperatives. He is a faculty member in the MBA program at the Rotman School at the University of Toronto. He also hosts a weekly conference call called Monday Morning Jump Start, which is about strategies for financial advisors. Advisors can see it on He can be reached at

As an investor, it's hard to avoid being impressed by the tremendous potential in China.

This was reinforced by a recent headline about a $2-billion contract to build trains for China won by Bombardier. Many of the MBA students from China in my class at the Rotman School at the University of Toronto are impressive and will certainly make strong contributions when they return to their homeland.

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That said, there are skeptics who question the payoff to investors from China's unquestionable growth.

So let's consider three questions: First, what's the basis for getting excited about China? Second, are there offsetting reasons for caution?

And finally, what's the actual experience been for investors?

Causes for optimism

One of the clearest voices on causes for optimism about China is Levi Folk, emerging market economist with the Excel Group of Funds, a fund company specializing in emerging markets.

Among the reasons for enthusiasm cited by Mr. Folk:

Continued prospects for growth in China's gross domestic product at levels three to four times what we'll see in developed countries.

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The sheer law of large numbers makes it an unstoppable force- with a population of 1.3 billion, China has 177 cities with over 1 million inhabitants.

Rising incomes are leading to a burgeoning middle class. The threshold for a middle class is the point at which people can afford to spend on discretionary items beyond food and shelter. By that measure, McKinsey Global Institute estimates that one third of Chinese are already in that category; this will grow to 70 per cent by 2020. (Note that the threshold for being a member of China's middle class is annual income of $3,000.)

Rising incomes will inevitably lead to growth in spending. McKinsey estimates that consumer spending will multiply five times by 2020, putting the Chinese consumer market into the third spot globally. Even today, 650 million Chinese own mobile phones, a number growing by 10 million a month - equivalent to a third of Canada's population.

Another reason for optimism is that Chinese business is starting to compete on the global stage - and not just as a low-cost manufacturer. A recent column by the chief executive officer of Thomson Reuters pointed out that historically patents didn't exist in China and it didn't adopt patent laws until 1985. China now issues 30,000 patents annually, behind only the U.S. and Japan - and is projected to be in first place by 2012.

Reasons for caution

China skeptics don't dispute these facts but point to a number of reasons for caution:

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First is the huge gulf between city dwellers and the 70 per cent of Chinese people who still live in rural areas. To this point, the vast bulk of benefits from economic growth has accrued to those in cities, creating significant tensions among those left behind.

There are questions about whether an authoritarian political regime can put the cap on demands for freedom among its increasingly educated youth - and whether conflicts will arise as a result.

Then there's the tenuous rule of law. While not at the level of countries like Russia, there is ample evidence that rules are stacked against foreign investors.

Finally, China has been unable to rationalize inefficient operations, as provinces have balked at central directives. For example, the country has thousands of small, inefficient steel mills - because local authorities resist the necessary consolidation for fear of losing jobs. Similarly, the focus on maintaining employment by China's provinces means they resist scaling back lending by banks to local businesses, even if they're losing money. (And we thought Canada had a monopoly on conflict between the federal government and the provinces.)

Another cause for concern is extremely low profitability by Chinese companies. Earlier this year, I attended a talk on "The China profit paradox," by a Harvard Business School professor who runs programs for Chinese managers. His research shows rapidly growing sales often lead to very low levels of profit by Chinese companies, well below their cost of capital.

The investor experience

Even given some legitimate causes for caution, the preponderance of evidence would seem to tilt towards a positive outlook.

So what's the actual investor experience in China been?

The global standard for tracking market performance is the MSCI Index, which has data for China going back almost 17 years, to the beginning of 1993.

According to MSCI data, if you'd invested $100 in World Stock Markets on Jan. 1, 1993, at the end of September of this year you would have had $321.

That same $100 invested in a cross section of emerging markets would be worth $431, reflecting the much rockier ride investors had along the way.

If you'd taken that $100 and put it into India, in August you would have had $571; note that almost all of India's growth happened in the last seven years, with the 10 before that being a wash.

In Brazil, that $100 investment would be worth a whopping $2,389.

And $100 invested in China almost 17 years ago (drum roll please) … at the end of August was worth $87, up from $58 at the end of last year.

At first I thought I'd made a mistake and double checked the data. Then I showed this to a number of industry veterans - none of whom thought this was possible and verified the numbers themselves, arriving at the same conclusion.

Making things worse, not only has China dramatically underperformed, but it's done so with incredible volatility.

In discussing these findings with Mr. Folk, he suggested that this might be due to the fact that Chinese public companies available in 1993 were inefficient state-owned enterprises that suffered in the intervening transformation of China's economy.

And that might well be the case.

Even so, this is a very big warning sign for anyone contemplating putting a significant part of their portfolio in China. The prospects for growth in China are inarguable - what's less clear is how much of that growth is already built into the price of Chinese stocks and whether outside investors will benefit from that growth in the same way as that country's citizenry.

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About the Author
Dan Richards

Dan Richards is a 20-year veteran of the investment industry and a faculty member in the MBA program at the University of Toronto’s Rotman School of Management. He has served as CEO of a major distribution firm with 3,500 financial advisors and is an expert on sentiment among Canadian investors. More


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