The China Small Cap Market in 2011

It’s almost not worth reliving, but sometimes reliving the bad experiences of the past helps you move forward and identify opportunities.

Anthony Bolton, manager of the Fidelity China Special Situations Fund said he best when he described 2011 in China equities as “BRUTAL”.

Bolton’s fund tumbled 38% last year. Most people would look at this track record and assume Bolton has no idea what he’s doing.

Hold the phone. The market takes Anthony Bolton very seriously when one considers Bolton managed $12 billion for Fidelity for 28 years, and averaged 19.5% annually over his tenure. Morningstar points out a $10,000 investment in his fund in 1979 turned into $1,494,118 in 2007.

Bolton’s $208 billion fund was heavily weighted to small and medium cap stocks. This sector was decimated by three separate head winds:

• The widespread accusations of fraud (in some cases proven accurate)
• The real estate and food driven spike in inflation in the Chinese economy
• The global slow down fostered by the European Sovereign debt and banking crisis

Any one of those three factors would have been enough for a weak market environment, but combining the three together led to the adjective “BRUTAL” by this seasoned veteran.

Bolton’s fund was down 38% in 2011. The China large cap market was down 22%- a dismal year by any standard. This, despite continuing fundamental progress by many of the more heavily followed China names.

China companies are doing very well- but the stocks have been dismal. The macro global picture trumped the company micro picture in 2011.

 

The Outlook for China Stocks 2012 

For starters, it would be hard for 2012 to be worse than 2011 for China equities. Aside from the normal stock market fluctuations off a terrible year, the macro picture in China is improving.

Q4 GDP growth in China was 8.9%. This is the slowest pace since 2009, but the median forecast of 26 economists was 8.7%. China is doing better than the economists realize.

China delivered full year GDP growth of 9.2%. The lowest estimate I’ve seen for 2012 is 7% GDP growth from Pimco, but most economists take a more moderate view in the 8% to 8.5% range.

Whether 7% or 8.5%, in this era of global crisis, China will still stand as the world’s fastest growing economy, boasting the largest emerging consumer class in the history of the world.

Economists are forecasting 12.3% industrial production growth in December ’11. While this growth is stronger than the rest of the world, it’s the smallest gain since August of 2009.

However, growth in retail sales is making up for the shortfall in the growth of industrial production. Retail sales in China are expected to grow 17.2% in December- a blistering pace.

7% to 8.5% growth in China in 2012 should actually bode well for equities. The Chinese government put the brakes on the economy in 2011 to slow down inflation, and it’s paying off.

Thanks to the cooling off of exports and the lower food costs, China inflation rate fell to its lowest level in 15 months in December, which should allow the Chinese government to ease monetary policy.

This past week, many commodities such as copper, soy beans, wheat, and oil traded to multi month highs this week which indicates a certain level of optimism concerning the global economy, spurred on by demand out of China.

In an interview with Bloomberg on Wednesday, Jim O’Neill, the Chairman of Goldman Sachs Asset Management, has some interesting observations.

O’Neill is the economist who coined the acronym “BRIC Nations”- referring to Brazil, Russia, India, and China.

O’Neill pointed out that if the Chinese economy were to grow a mere 7.5% for this entire decade (he is forecasting this), it would contribute more to world growth in dollars than the US and Europe combined.

O’Neill also forecasts a China style democracy will evolve. While the Chinese citizenry is saying the want more freedom, what they really want is more wealth.

There’s still 1 billion people in China who have nothing by modern standards, and they all want wealth. It’s the largest emerging consumer class in the history of the world.

While all this macro stuff is happening, things are shaping up on a micro level as well. I’ve studied nearly 100 small cap charts this past week, and there’s a few that are really shaping up beautifully.

There haven’t been many fraud accusations of late, and the 2011 audits of China small caps will start coming out next month.

There will be massive scrutiny from the audit firms considering the heat that has befallen the sector, so these will be the most reliable audits on China small cap to date.

It’s time to start getting engaged in this sector again if you’ve been on the sidelines.