Over the past decade, China has become a bellwether for global economic growth; when China’s economy slows, investors assume that’s a dismal portent for the rest of the world. So it’s little surprise that the recent decline in China’s economic growth has inspired dour headlines in the financial media. But Edmund Harriss, portfolio manager of Guinness Atkinson China & Hong Kong (ICHKX, 800-915-6565), believes that investors can still find opportunities in the Middle Kingdom in the midst of a slowdown. He says the Chinese government has clearly signaled its intention to reorder its domestic economy and that international investors who focus on the right sectors can still reap profits from the country.

Please describe your investment process.

We primarily use a bottom-up investment discipline. However, we also employ a top-down analysis because China’s economy is so heavily policy driven that it’s important to understand how policies originate and how they’ll impact the operating environment. China’s domestic economy is actually a hybrid of state-controlled elements and free market elements. As such, there are potential fault lines where the state-controlled segments have prices governed by policy geared toward containing inflation, while the other segments are more market driven. For example, electricity producers’ revenue has suffered from price controls, but they also face rising input costs from market-priced commodities such as coal.

Our fund is positioned toward domestic economic activity rather than external activity, so we haven’t held a substantial weighting in export manufacturers for a number of years. China is concentrating on developing its domestic economy to engineer a shift toward a more self-sustaining economic model. From an economic perspective, export manufacturing still plays a crucial role in China’s economy because it’s the source of the higher wages that drive consumer demand. But export-oriented businesses are not attractive investments because of pressures they face from falling demand, rising input costs and wage inflation.

Is the worry over China’s slowdown justified?

I’m surprised the market has taken this news so hard. The Chinese government was noticeably more cautious about its expectations for future economic growth than a number of external forecasters, but somehow that was ignored. The market focuses heavily on gross domestic product (GDP), which is a highly politicized number, instead of paying greater attention to underlying economic indicators, which pointed toward slowing domestic economic activity. For instance, we know full well that China’s export manufacturing sector is going to feel the impact of weaker demand from the US and particularly from Europe, so that alone suggests slower GDP growth.

Looking at GDP growth with the idea that growth equals profits that then translate into stock market returns just isn’t true. There are all kinds of growth that are not profitable. For example, if a road is built, but there’s nothing at either end of it, then the road serves no useful purpose whatsoever. But the fact that the road was built is actually counted toward GDP. So one criticism of placing such an emphasis on GDP is that 10 percent GDP growth isn’t necessarily a good thing and can mask quite a bit of waste.

China’s slowdown requires a more nuanced analysis. While its economy may be slowing, it’s still growing faster than most countries in the rest of the world. So we try to find the sources of future growth and direct our investments accordingly.

China is moving to a slower, but more profitable growth model over the coming years. So we’re focusing on domestic stimulus efforts such as social housing construction programs, which will support consumer durables manufacturers; efforts to boost consumption through rising wages; and some fiscal stimulus measures. Meanwhile, we remain cautious about areas where the government is attempting to rein in prices, such as the real estate sector, or areas where the government is unable to exert much influence, such as external demand for manufactured goods.

The market’s negative reaction to the government’s lowering of its official GDP growth target to 7.5 percent is a highly simplistic way of viewing the situation in China. This latest policy is merely formal recognition that growth will not be as robust this year as it was in years past. It’s also a sign that policy will be much more supportive of growth in the coming year after having restrained growth for the past 18 months.

So part of this slowdown is due to the fact that China hopes to spur domestic growth instead of relying on demand from overseas?

Yes, I would say so. There are two elements that are responsible for slower growth.

In 2009, China launched a massive stimulus package as the world spiraled into the financial crisis, and much of that stimulus money was spent on infrastructure development. These projects are nearing completion and infrastructure spending is on the decline. That suggests the Chinese believe that any further investment in this area would be wasteful.

As these infrastructure projects run their course and are not replaced, that hurts the construction sector. So the Chinese are looking for an area that can boost the construction industry without being wasteful. That’s where their social housing program comes into play. China’s latest five-year plan calls for the construction of 36 million units of affordable housing.

The private real estate sector has been significantly overpriced and the government is attempting to control property prices. One way they aim to achieve that end is to restrict credit, which dampens speculative demand. The other way is to increase the supply of affordable housing. An increase in the amount of affordable housing will not only bring property prices down to more realistic levels, but more people can then afford to buy their own homes and set up a household.

While we talk a lot about urbanization and how that contributes to growth, the urbanization ratio is too broad of a measure to use when analyzing China’s domestic economy. The rate of household formation within urban areas is what will ultimately drive domestic demand because it influences the purchase of consumer durables such as furniture. So this social housing program supports household formation and consumption in the short term, which should drive economic growth. And in the longer term, this program should create a demand pull for additional consumer goods, which will help China transition from its overdependence on investment and increase the share of private consumption.

On the export manufacturing side, net exports are still positive, but they’re lower than where they were last year. From 2006 through 2008, net exports contributed roughly 2 percent or 3 percent to GDP growth each year. But this year, net exports will probably detract from GDP growth.

How big a role does Europe play in the slowdown?

Europe is a major Chinese trading partner, accounting for 20 percent to 25 percent of Chinese exports. That’s a substantial portion of external demand, and we’ve seen a material slowdown in Europe. By contrast, China’s exports to the US have held up surprisingly well, and that’s largely a function of the fact that the US economy is in better shape than the rest of the developed world. China is searching for ways to offset the effect of the decrease in European demand on its manufacturing sector, so spurring domestic demand is one way to do that.  

China is going through its decennial leadership change. What effect might that have on the Chinese economy?

The role of China’s leadership is to create economic conditions that improve the lot of their people. Both their domestic policy and their international relations are geared toward that end and everything they do should be viewed through that prism.

When dealing with the US and Europe, China’s goal is to negotiate favorable trading conditions and acquire technology to strengthen their industrial base. The hope is that successes on these fronts will enhance the country’s standard of living, while also leading to job creation. This perspective often seems to get overlooked in the various reports I’ve read about China, particularly those submitted to the US Congress. The editorial tone of these reports is polemic, with a focus on the idea that China is somehow out to get us. They’re not. They’re trying to secure a better future for themselves, which provides the government with greater stability.

From that point of view, I think the new leadership will move further toward economic liberalization, though not political liberalization. They’ve already started down that path with the creation of the offshore renminbi market in 2010, which now introduces the notion that renminbi can be traded offshore and is convertible within a limited framework. China ultimately hopes the renminbi will become an international currency, particularly since China already accounts for about 10 percent of world merchandise trade, which is worth about USD3.5 trillion. Most of China’s trade is settled in US dollars and they’d like to use their own currency instead. A flexible currency also acts as a shock absorber against changes in the external environment.

But before the renminbi can become an international currency, China needs to offer opportunities for foreign holders of renminbi to invest the currency. At present, China is developing onshore financial markets, such as government bond markets and corporate bond markets, and to some degree a disintermediation of the banks. They will also need to regularize their interest rate environment rather than rely upon an administrative system. The end result of these changes will be a domestic system that is more market driven to support a monetary system that is internationally usable, convertible and perhaps eventually a reserve currency. While China’s economy has become broader, deeper and more complex, its present financial system is too rigid to cope with that.

Where are the pockets of strength in China?

Energy, materials and industrials are still the areas that, from a value perspective, interest me most. From a growth perspective, these industries are still benefiting from China’s efforts to create a consumer-driven economy.

So we’re playing this theme through investments in the auto sector such as Dongfeng Motor Group (HK: 0489, OTC: DNFGF). It manufactures auto-mobiles with smaller engines that are generally more affordable than premium brands.

On the technology side, we favor Internet stocks such as game portal NetEase.com (NSDQ: NTES) and online portals such as Tencent Holdings (HK: 0700, OTC: TCEHY) and SOHO China Limited (HK: 0410, OTC: SOHOF). They reflect the ability and willingness of younger and wealthier Chinese to spend. These stocks also offer good value because they’re asset-light and generate significant cash flow. The standard approach to playing consumer demand is to focus on the retail sector. But what some investors fail to apprehend is that businesses that operate in this sector require substantial capital and face intense competition.

We also like China Mobile (HK: 0941, NYSE: CHL), a mobile phone business with about 655 million customers. It has a strong balance sheet and a good track record of managing itself and maintaining investment returns. China Mobile also pays an attractive dividend, with a 43 percent payout ratio. The company has been trying to transition into 3G technology, but has been hindered by China’s desire to develop a domestic version that hasn’t really worked. Instead, it’s now poised to jump straight into 4G. China Mobile is also a play on domestic consumption because about 90 percent of revenue is still derived from voice service and text messaging. As disposable incomes continue to rise, data usage will become an increasingly important source of revenue.

Many investors are leery of Chinese companies in which the government has a stake. Should that be part of one’s analysis?

When you analyze a company, you shouldn’t be overly concerned with whether the government has a stake in it. Instead, you should focus on whether the company generates steadily improving returns on investment and what is driving those returns. That, in turn, means calculating how much the company spends to produce a product and how much it makes after selling it. Is it operating in a sector that is free from intervention so the price of its products is set by the market? What is that company’s role in the market? Is it a policy-driven company or a genuine commercial entity?

Avoiding government-owned companies is a dogmatic position that plays well with some parties, but if you totally avoid such businesses, you might find yourself investing in companies that are completely shut out of the market. So you really need to analyze the underlying business.

You can determine how well a business operates commercially by examining how it’s performed over the past ten years. Over a long-term period, problems become more apparent because it’s difficult for companies to continue hiding them for more than several quarters. When examining a company’s financial statements for oddities, you might see peculiar changes in working capital, strange investment programs, or capital expenditures that have suddenly ramped up for no good reason. Or you might find changes in margins that are difficult to explain.

In addition to export manufacturers, should investors avoid any other sectors?

From a current investment standpoint, I’m not especially fond of the banking sector. Banks are approaching their loan-to-deposit ratio ceiling of 75 percent, especially the mid-tier banks, so they’ll need to raise additional capital in order to keep lending. Should that happen, then it might encourage larger banks to follow suit.

However, I’m not particularly concerned about nonperforming loans, which is an area that’s caused considerable anxiety for other investors. China’s banks have a substantial capital base and are well funded. Unlike Western banks, Chinese banks don’t rely on wholesale markets, and they have a large, captive deposit base. And a bank that’s funded by a substantial deposit base is a more secure institution.

Additionally, China is unlikely to face a potential debt crisis any time soon because it has a closed capital account and most of its debt is incurred domestically. That means it won’t face the sort of pressure from external institutions that helped spark the sovereign-debt crisis in Europe. But while the banking sector is secure from a macroeconomic perspective, it doesn’t offer any investment opportunities right now because banks need to raise additional capital.

What is your best piece of advice for investors over the next year?

US investors should seriously consider building an allocation to international investments. The US economy is improving, but it’s still vulnerable to a rising interest rate environment, rising inflation or a combination of both.

Emerging markets may seem risky, but they’re well capitalized and growing. And that growth has been spurred by a burgeoning middle class with rising disposable income. So emerging markets are a particularly attractive place for investors to put new money to work.