Just Fine

FALLS CHURCH, Va.–After a look at global markets, I can’t help but think that my long-held view–namely, that the bears will have to wait a little longer–might materialize.

A month ago I wrote that, as things then stood, world stock markets could stay stronger for longer, even after four rewarding years. Equity valuations remain at fair levels (although not as cheap as they were) and earnings continue to be strong. The global economy doesn’t look bad yet, but it is decelerating (see SRI, 23 December 2006, Pushing the Envelope). World markets are up nearly 2 percent (a 20 percent annualized return) and investors’ animal spirits remain alive. Current conditions leave me with a reasonably bullish attitude–but not complacency.

The bearish case does have merit; things look frothier now than a year ago, when I was outright bullish. Few remember the dark days of last summer’s selloff, but that lack of recall doesn’t mean another such nasty surprise won’t happen again. Downside risk may be forgotten, but it’s not gone.

When it comes to Asia, to focal point of the SRI Portfolio, the region’s economies as well as its markets are well positioned to offer more upside, absent a global recession. Asia had an excellent 2006, marked by strong market conditions and currencies, and you can’t rule out a repeat in 2007. Most important, the structural case for Asia has only begun to unfold.

The Portfolio will remain overweight Asia (including Japan), with Russia and Western Europe in the mix. Far-sighted investors should have serious exposure–to the tune of 30 percent to 50 percent–in Asia, depending on individual risk characteristics and investment horizons. This allocation recommendation assumes a well-diversified portfolio, the purpose of which is to reduce overall volatility as some assets appreciate while others depreciate.

China Restructuring

A couple days ago the National Financial Working Conference, a gathering of China’s financial agencies, concluded its annual strategy meetings. The Conference approved a measure allocating part of China’s burgeoning foreign exchange (FX) reserves to strategies aiming at higher investment returns. A state investment company–which will report directly to the State Council–will be created to carry out the plan. It’s obvious, given China’s FX reserve levels, that the decision will have big (though not immediate) consequences for the financial markets and the global economy.

China’s FX reserves have surpassed USD1 trillion after increasing by about USD20 billion a month in 2006, and I expect another USD300 billion to be added this year. The National Financial Working Conference indicated that mainly the new reserves will be diverted to the state investment company–expect a big part of this year’s accumulated reserves to be directed to global financial markets, a positive for stocks around the world.

The Conference also decided to concentrate efforts on improving the rural financial system and restructuring the Agricultural Bank of China, which should further the government’s goal of boosting domestic demand.

It’s well known now that the Chinese government is geared toward enhancing domestic demand growth in an effort to reduce the economy’s exposure to manufacturing. The state’s current five-year plan (2006-10) specifically refers to the “expansion of domestic demand” in an effort to increase the “consumption share of GDP.”

The measures being implemented include an increase in the basic deduction for personal income tax to RMB1,600 for middle- and low-income Chinese, accelerating infrastructure projects in rural areas and improving social systems for education, medical services and retirement.

Although manufacturing still dominates China’s GDP, the foundations for an increase in consumption are being laid. For starters, incomes in urban China have been rising as the urbanization ratio has reached 43 percent.

urbanincome012407

Source: Bloomberg

At the same time, annual expenditures on consumption have also been rising and should continue to do so–the government has explicitly said that its target is to raise per capita GDP to USD3,000 by 2020.

urbanconsumption012407

Source: China Statistical Yearbook

In light of these changes, I’m adding another domestic consumption-related stock to the Long-Term Portfolio, Hengan International (OTC: HEGIF).

Established in 1985, Hengan is the largest sanitary napkin manufacturer and the second-largest disposable baby diaper manufacturer in China; it’s also a leading producer of high-end tissues. It started making sanitary napkins in China in the early 1990s, effectively creating the market, and built a strong brand name and distribution network.

The main growth engine of the company is its diaper division–diaper demand is growing strongly, driven by demographic change and rising living standards. Although disposable diapers have been available for 20 years in China, industry growth has picked up to 40 percent–60 percent in Hengan’s case–during the last couple years as young parents in urban areas see their incomes rising.

diapersales012407

Source: Hengan International, China National Household Paper Association

Young couples, are willing to spend more on child care products, food, entertainment, and education. Child-related consumption accounts for a relatively large share of overall household spending. As the population of Chinese between the ages of 0 and 6 in urban areas is expected to continue to increase for at least another five years, the opportunity will remain intact for quite some time. Diapers have a low penetration rate in China at around 7.7 percent, but that will change as the financial situation of the Chinese consumer improves.

For Hengan, diapers represent 25 percent of total sales but only 15 percent of operating profits because of lower margins (31 percent). Sanitary napkins and tissues post margins of 55 and 36 percent, respectively. The main reason for the low margins is that diapers have a relatively low selling price, as they’re not yet regarded as a necessity.

But the company has been able to constantly improve its market position and its average sale prices. And Hengan has been acquiring a greater diaper market share through the introduction of higher-end diapers.

Hengan is a strong brand name in China and branding is very important to the Chinese consumer. Hengan sells its tissues at a 5 percent premium over its larger competitors (premiums are much larger over smaller competitors), indicating both brand and quality leadership. The company has developed an excellent distribution network, while none of its competitors offers a full range of sanitary napkins, diapers and tissues.

Provided that domestic demand continues to grow and living standards remain on the increase, Hengan should be able to at least maintain its market share and growth rate, and perhaps boost both as the market consolidates and the bigger players solidify their positions. Buy Hengan International.

hegan012407
Source: Bloomberg

Investment Approach

Due to the fact that SRI has seen an influx of new readers, I’d like to offer an explanation of the way I view the investment process.

The first step when you become an SRI reader–with its emphasis on global markets, emerging markets in particular–is to understand the argument that Asia will be a very important economic region in coming years. The next step is to contemplate that evolution and then act in a long-term fashion. Many investors have tried the “smart” way of trading Asian markets or have searched for the latest “hot” story to make a quick profit. These people ignore the big picture, and their profits are relatively small.

Long-term readers know that I haven’t positioned the SRI Portfolio in that manner and that I didn’t work like that when I was responsible for stock selection and sector allocation for another financial advisory. In other words, generating long-term, positive returns while avoiding short-term downside is the theory upon which I’m constructing the SRI Portfolio.

And I make every effort to alert investors when I see moves to the upside or the downside or any other special situations.

The approach here is top-down. I first identify long-term investment themes (or, as my colleagues and I call them, global secular trends). Because of the long-term approach, the Portfolio must be able to endure short-term volatility as long as we continue to be on the correct side of the global secular trend. To achieve this, the Portfolio is being constructed to offer a diversified set of holdings, while I also offer hedging ideas for more-complete advice.

A characteristic common to the Portfolio companies is suitability for the new realities of a changing world. They’ll benefit the most from the changes taking place in the global economy.

No one knows how long it will take for the global economy to navigate the secular trend identified here. This is the reason investors need to remain focused and have a portfolio that can last and perform well on a tactical basis. After all, the way to stay in the game isn’t by losing all the money, and tactical mistakes can cause that. This is the main reason I won’t put convictions above analysis and will avoid suggesting only one type of attitude or trade, especially short-only strategies.

It’s important that you look at the Portfolio as a whole and not as an assortment of stock tips. Although few people will buy the Portfolio in its entirety, you, at the very least, need to buy SRI’s investment theme in order to diversify. Buying only banks or tech companies because you like the stories may offer a reward, but such an approach won’t provide the lasting benefits of the overall Portfolio.

Keep in mind that SRI comes to you weekly and always offers current advice. Adding and subtracting stocks from the Portfolio can be done more easily this way. There’s always another week, and neither readers nor the editor need to rush. Patience has always been a good thing to have when investing.

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