China’s Domestic-Consumption Stocks Overtake Exports

America’s economic troubles hang like a dark cloud over stock markets around the world, but a major segment of Chinese stocks enjoys a silver lining. Companies that get most of their revenue serving China’s domestic market already have been popular with stock pickers for several years, largely because of the country’s prodigious economic growth. This year, the U.S. economic slowdown adds to their appeal compared to many other stocks in China.

Domestic-consumption stocks now look even better than Chinese stocks focused on exports because the slowdown in the U.S. dulls the voracious appetite for Chinese products. “Domestic-market stocks have been in favor for quite awhile,” says Paul Lee, an analyst for Tai Fook Securities. “But they’re even stronger because exports are under pressure in 2008.”

In addition, the sluggish economy in the U.S. helps decrease the biggest threat to Chinese domestic consumption—stringent economic tightening by China’s government. Authorities have already repeatedly raised interest rates and taken other measures to cool off an economy in danger of overheating. Then inflation began to rise ominously in late 2007. But worry over more drastic tightening receded as weakening demand from the U.S. and other countries hurt China’s export prospects. “As the export sector slows, the money supply will also slow … and actually ease the possibility of inflation,” Lee says.

There are other substantial factors boosting consumption-oriented stocks. The Chinese government is pushing a strategic effort to boost domestic consumption, partly to decrease dependence on exports. The surge in exports draws considerable heat from the U.S. and other countries, and tends to promote low-paying jobs in polluting, energy-hungry light industries. Local consumption is also seen as a partial replacement for fixed-asset investment, which is often wasteful, as a driver of the economy.

Although the domestic-consumption sector is attractive, not all of the stocks are winners. Each day, Batterymarch Financial Management uses fancy number crunching supplemented by fundamental analysis to rate all available stocks according to value, growth, expectations, and technical factors. Ray Prasad, Batterymarch senior portfolio manager for emerging markets, says consumption-oriented stocks make up the preponderance of Chinese companies that Batterymarch purchases or recommends to CalPERS and other institutional investors.

“We continue to like domestic agriculture plays,” says Prasad. “Companies involved in processing food are fairly cheap and growing well.” Overall, some individual companies that used to be attractive are now too pricey or have lost growth momentum, and not all domestic-consumption sectors are hot as a whole.

Companies involved in infrastructure are a mixed bag. Some are fairly attractive, but some aren’t meeting growth expectations. Some financial stocks have been beaten down in price. Batterymarch underweights the sector, but is slowly building up its position. Retail stocks have been out of favor with Batterymarch, but that is changing. “Some have value and are starting to look attractive,” says Prasad.

Batterymarch does not provide the names of its stock picks, but Lee and other experts recommended both sectors and individual stocks listed in Hong Kong. Ben Kwong, chief operating officer of KGI Asia, and Andy Mantel, CEO of Pacific Sun Investment Management, both like retail and food-producing stocks. Kwong notes that Chinese retail sales of consumer goods jumped 16% year-on-year through October of last year.

China Resources Enterprise Ltd. (HKG: 0291): Both Kwong and Mantel favor this retailer, which operates extensive supermarket and hypermarket chains. “Some new stores are being opened in still remote areas,” says Mantel. Kwong points to attractive valuations, namely a prospective P/E ratio of 25 for 2008.

Li Ning (HKG: 2331): According to Kwong, Li Ning, a sportswear company, will benefit greatly from the 2008 Beijing Olympics, as it has associated its brand with the event. Net profit is expected to surge 39% from 2006 to 2009, largely due to growth in the sportswear market.

China Green (HKG: 0904): This company features high-margin processed foods and branded products such as beverages and frozen vegetables. “The company has built a reputation on safe and tasty products, and customers do not mind spending a bit more money for their products,” says Mantel.

Industrial and Commercial Bank of China (Asia) (HKG: 0349): ICBC serves Chinese consumers and companies through the most extensive branch network in the country. This size and reach will be especially profitable when authorities allow banks to enter investment and insurance businesses—which Lee says will come “sooner or later.

— By Gene Linn