Posted On: Thursday, October 04, 2007

Author: Monty Guild and Tony Danaher

"Genius, that power which dazzles mortal eyes, is often perseverance in disguise"

-Henry Willard Austin

I just returned from a trip to China and Hong Kong. My first impression of Los Angeles International airport and the drive from LAX to our offices Monday afternoon was one of amazement at how much more elegant, clean and orderly the airports and auto routes of Shanghai and Hong Kong are compared to those in Los Angeles. It seems if one was to compare just these few things, the U.S. would look like the third world country and China, the first.

The trip was fairly grueling, filled with meetings with companies, analysts and economists, late planes and a lot of information crammed into about 10 days...but it is a joy to experience the world as seen through others eyes and to see how they think and react to issues that we may recognize and react to in a much different manner. In short, it was educational and in our opinion, learning is one of life's great joys.

Main take away points:

1. China and Hong Kong continue their economic boom, and the stock market boom there will probably continue for some time into the future. This does not mean that there will not be major declines. These declines have recently been short (often only a few weeks) and volatile. These are volatile markets, but if one buys the dips, there will be substantial rewards over the long term, in our opinion. China is currently experiencing a stock market boom and a residential real estate boom. The cause of these is the cash being built up in the banking system as a result of the fast GDP growth rate.

2. The economic growth rate in China will likely fall from about 11.5 % currently to 10 to 10.5% in the next year. That is still exceptionally fast economic growth by any measure. GDP growth of 10% can probably be correlated with corporate profit growth in excess of 20% for the average company. This implies that many individuals' wealth will be growing at a rate well in excess of 10% per annum.

Not unreasonably, these individuals will desire to maintain and grow their assets at a rate at least equal to (and hopefully in excess of) the inflation rate. As you know inflation is a growing problem in China and bank deposits in China currently pay less than 5% interest. Last month, inflation was in excess of 6%.

3. In our opinion, much like the U.S. investors in the 70's, Chinese investors will use residential real estate, precious metals and stocks to stay in front of the inflation-led decrease in buying power of their assets.

Key Take Away Point

Recently, the government has instituted new measures to discourage speculation on residential real estate. Now investors must make a down payment in excess of 50% to buy a second home. Additionally, interest rates are higher on second homes than on other real estate transactions. As money exits the residential real estate market it flows into Chinese equities.

4. China is not growing mostly due to exports. Of the current 11.5% growth rate, 9% is from domestic growth and 2.5% is from export growth. Thus, domestic demand is growing much faster than export demand. This is a positive for the valuation of stocks in China.

We have noticed over the years that countries where the growth is from domestic demand are accorded a higher valuation than markets where most of the growth is from exports. The argument is that growth in domestic demand is generally more repeatable than growth in exports. With exports, many external forces like price cutting, inventory cycles and competition impact growth and are out of the control of exporters.

5. Another positive is that even if the U.S. and possibly Europe fall into recession, China and India may slow their torrid growth rates but they will continue to enjoy very rapid growth. We believe that it is eminently reasonable to believe that this rapid growth will attract money from other markets seeking higher returns.

6. China exports more to non-Japan Asia, Japan and Europe than it exports to North America. North America is the fourth biggest export region for China, although some of the exports to other parts of the world may be further processed and re-exported to the developed North America. This does not impact total exports much.

IN MANY CASES, THE SAME STOCKS TRADE IN HONG KONG AT SUBSTANTIAL DISCOUNTS TO WHERE THEY TRADE IN CHINA

1. Many mainland China investors are shifting assets to Hong Kong. This trend is just beginning and will continue for many years. It is taking take place in the form of large institutional investors now, and eventually retail investors will be able to diversify their stock market assets outside of China.

2. China has not been caught up in the credit crisis which plagued the developed world in 2007. For example, insurance companies in China are not allowed to loan on real estate at all. Thus, their holdings of bad mortgage derivative paper are very small. The perceived lesser risk of a financial accident is attracting investors to India and China.

3. The China sovereign wealth fund of $200 billion has started to invest globally. It will be called China Investment Corporation Ltd. We expect that fund to skyrocket in size over the next decade and we expect the fund to invest broadly in companies on a global basis. Initially, the focus will be on Hong Kong and Asian markets. In our opinion, this is a positive for world stock markets.

THE CREDIT CRISIS......A BOON FOR DEVELOPING MARKETS......ESPECIALLY THOSE WITH FAST GROWTH

Money is leaving developed markets in search for growth that will be uninterrupted by an economic collapse and or the meltdown of derivatives. Obviously, those countries with a balance of payments surplus and strong economic growth will be the destination for a lot more global capital in coming years.

OUR THEMES OF CHINA, INDIA, SINGAPORE, GOLD, NON U.S. CURRENCIES, ENERGY AND BASE METALS HAVE ONCE AGAIN WORKED OUT WELL

It is simple economic and political analysis, observation and persistence. The credit crisis of 2007 has only amplified the attraction of these investments. Our themes remain the same.

Thanks for listening.

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