By ED LIN
OF ALL THE EMERGING MARKETS, one would imagine that China would be one of the most volatile places to invest. Surely a fund that plays the country would have a minimum annual turnover of at least 100%.
But Edmund Harriss, manager of Guinness Atkinson China & Hong Kong (ticker: ICHKX), runs a fund that had a turnover of a scant 8% in 2009. "I try to keep it really low, because I don't trade these stocks," says Harriss. "We did virtually nothing in 2009."
Yet the fund rocketed 92.8% that year -- more than 12 percentage points over the benchmark Lipper's China index. The fund's three-year annualized return of 11.9% also tops the index's 8.8%.
"Our portfolio is pitched toward energy and industrialization," says Harriss. "Consumption, we play through technology and through autos. We've got some commodities plays and construction plays through a little bit of real estate, and steel and metals."
China has been in a transition phase for the past 30 years, as Harriss sees it. "It is in the interest of the government to promote growth and bring people in from the agrarian side of the economy into the urban side, where they can see uplift in incomes and, therefore, wealth can be spread."
Harriss recently spoke with Barrons.com by telephone.
Barrons.com: The fund seems pretty heavily weighted to energy.
Harriss: Yes. For the moment China's policy is geared toward industrialization, expansion particularly in areas of construction and heavy industry. These are the areas that employ the most number of people. China has about 12 million people entering the workforce every year, as well as a similar number who are migrating [to factories from rural areas].
They have been increasing the amount of electricity-generating capacity by something in the order of 60 to 80 gigawatts a year. Now that's about the size of the entire in-store capacity of Great Britain, and they have been doing that each year for the past five years. The bulk of that is coal-fired. China consumes about 2.2 billion tons of coal of a year. About half of that is going into the power sector. In the construction area, the biggest component is steel. Steel also requires considerable quantities of coal in its manufacture.
Barrons.com: Yanzhou Coal Mining (YZC) is your top holding. Is that primarily steam coal or metallurgical coal?(锅炉用煤还是炼焦煤)
Harriss: It is primarily steam. China has next to nothing in metallurgical coal. I like Yanzhou, one of the smaller producers, because it is one that is most geared to the spot market rather than contracts. And at the moment, spot prices are moving up well ahead of contract prices. Whereas last year their contract prices were largely supplying to power stations at around $60 a ton, in the spot market they could be getting $80 to $90 a ton. They've also been looking to expand their capacity through an acquisition in Australia.
Q: Is it your top holding because of the movement in the stock price or have you been adding more?
A: I'd start out with something in the order of a 2.5% position in the fund. When it gets higher than that, it is because the stock price has moved. Here I am blowing my trumpet, but [battery and alternative-energy car developer] BYD Co. was a stock that in the middle of last year was about 10% of the fund. Once it got there, I thought that's a heck of a size, so we halved that and have taken a little bit more off the table.
Q: Did the news of Berkshire Hathaway's (BRKA) interest in the stock help? [Editor's Note: A Berkshire Hathaway unit bought a 10% stake in BYD in late 2008.]
A: The Buffett news helped a lot, and I'm happy to say I had moved into that stock earlier. It was a reasonably good quality battery maker in mobile phones and had an emerging auto business that was gaining some traction. So I thought this would be an interesting stock to hold, and it did very well. But once Buffett came in, it sort of took it to a whole different valuation range. BYD's auto business has grown fantastically well in the last 18 months. They've sold more cars in the third quarter of 2009 than in the first half of 2009. By the end of 2009, I think they sold something on the order of 400,000 cars.
Q: How viable a prospect is their electric car?
A: I think it is viable, and what makes it an interesting play is that they are the one company in China with the experience in batteries. They started out on this project back around 2001. BYD said [they were going] into electric cars, and everyone just laughed, because all they had done was batteries and mobile phones. But they stuck with it, and they have a product that works. If you are going to go down the battery route in China, and you are going to be doing it with a Chinese partner, that partner will be BYD.
Q: Let's talk about Cnooc (CEO, 中海油) and PetroChina (PTR, 中石油). What opportunities do they have?
A: Cnooc is what I prefer. Cnooc is an exploration and production business. PetroChina is an integrated business: It has exploration and production, refining, and a growing gas business, which at the moment has yet to contribute significantly. They have been investing hugely in a massive gas pipeline. PetroChina is really a play on China's gas story, and China wants to make more use of natural gas. They have been importing a fair amount of it, and initially there were plans to build these storage facilities about 10 of them on the coast of China. In fact, only two were ever built. They have these gas reserves in the western parts of China, and the problem is to get that gas over to the eastern coastal provinces.
When looking at PetroChina in detail, you can model the exploration and production bit fine. You can model the petrochemical side as much as one can. But the refining business is the one that contains an unknown. You simply don't know how much money that business is going to make because the product prices are fixed, and in order to keep these refiners in business, the government effectively gives them a subsidy. There is a tax that exploration and production companies have to pay on oil production that goes toward paying the subsidy to the refiners, which keeps product prices at a reasonable level domestically. So, you have no idea how much of a subsidy the government is going to hand out -- that's what makes it a tricky business.
Q: Hence, Cnooc is preferred? OF ALL THE EMERGING MARKETS, one would imagine that China would be one of the most volatile places to invest. Surely a fund that plays the country would have a minimum annual turnover of at least 100%.
But Edmund Harriss, manager of Guinness Atkinson China & Hong Kong (ticker: ICHKX), runs a fund that had a turnover of a scant 8% in 2009. "I try to keep it really low, because I don't trade these stocks," says Harriss. "We did virtually nothing in 2009."
Manager's Bio
![[Harriss icon]](https://lh3.googleusercontent.com/blogger_img_proxy/AEn0k_t9u-LzmaVCaRBJkjDAjcdaXt554cDsleVj01QQ3dk26xLVPtxiaprgzklvvX5hKZ1hJlKDIGEcaJtvKQ8B8a1EgoDeKY2zeP9Q2ioDGIRCbq0hH7xIMrqOGd_cmQnExIv7gaTfe0ud7FGRjObchS4bZ5UaajHlDA=s0-d)
Name: Edmund Harriss
"Our portfolio is pitched toward energy and industrialization," says Harriss. "Consumption, we play through technology and through autos. We've got some commodities plays and construction plays through a little bit of real estate, and steel and metals."
China has been in a transition phase for the past 30 years, as Harriss sees it. "It is in the interest of the government to promote growth and bring people in from the agrarian side of the economy into the urban side, where they can see uplift in incomes and, therefore, wealth can be spread."
Harriss recently spoke with Barrons.com by telephone.
Barrons.com: The fund seems pretty heavily weighted to energy.
Harriss: Yes. For the moment China's policy is geared toward industrialization, expansion particularly in areas of construction and heavy industry. These are the areas that employ the most number of people. China has about 12 million people entering the workforce every year, as well as a similar number who are migrating [to factories from rural areas].
They have been increasing the amount of electricity-generating capacity by something in the order of 60 to 80 gigawatts a year. Now that's about the size of the entire in-store capacity of Great Britain, and they have been doing that each year for the past five years. The bulk of that is coal-fired. China consumes about 2.2 billion tons of coal of a year. About half of that is going into the power sector. In the construction area, the biggest component is steel. Steel also requires considerable quantities of coal in its manufacture.
Barrons.com: Yanzhou Coal Mining (YZC) is your top holding. Is that primarily steam coal or metallurgical coal?(锅炉用煤还是炼焦煤)
Harriss: It is primarily steam. China has next to nothing in metallurgical coal. I like Yanzhou, one of the smaller producers, because it is one that is most geared to the spot market rather than contracts. And at the moment, spot prices are moving up well ahead of contract prices. Whereas last year their contract prices were largely supplying to power stations at around $60 a ton, in the spot market they could be getting $80 to $90 a ton. They've also been looking to expand their capacity through an acquisition in Australia.
Q: Is it your top holding because of the movement in the stock price or have you been adding more?
A: I'd start out with something in the order of a 2.5% position in the fund. When it gets higher than that, it is because the stock price has moved. Here I am blowing my trumpet, but [battery and alternative-energy car developer] BYD Co. was a stock that in the middle of last year was about 10% of the fund. Once it got there, I thought that's a heck of a size, so we halved that and have taken a little bit more off the table.
Q: Did the news of Berkshire Hathaway's (BRKA) interest in the stock help? [Editor's Note: A Berkshire Hathaway unit bought a 10% stake in BYD in late 2008.]
A: The Buffett news helped a lot, and I'm happy to say I had moved into that stock earlier. It was a reasonably good quality battery maker in mobile phones and had an emerging auto business that was gaining some traction. So I thought this would be an interesting stock to hold, and it did very well. But once Buffett came in, it sort of took it to a whole different valuation range. BYD's auto business has grown fantastically well in the last 18 months. They've sold more cars in the third quarter of 2009 than in the first half of 2009. By the end of 2009, I think they sold something on the order of 400,000 cars.
Q: How viable a prospect is their electric car?
A: I think it is viable, and what makes it an interesting play is that they are the one company in China with the experience in batteries. They started out on this project back around 2001. BYD said [they were going] into electric cars, and everyone just laughed, because all they had done was batteries and mobile phones. But they stuck with it, and they have a product that works. If you are going to go down the battery route in China, and you are going to be doing it with a Chinese partner, that partner will be BYD.
Q: Let's talk about Cnooc (CEO, 中海油) and PetroChina (PTR, 中石油). What opportunities do they have?
A: Cnooc is what I prefer. Cnooc is an exploration and production business. PetroChina is an integrated business: It has exploration and production, refining, and a growing gas business, which at the moment has yet to contribute significantly. They have been investing hugely in a massive gas pipeline. PetroChina is really a play on China's gas story, and China wants to make more use of natural gas. They have been importing a fair amount of it, and initially there were plans to build these storage facilities about 10 of them on the coast of China. In fact, only two were ever built. They have these gas reserves in the western parts of China, and the problem is to get that gas over to the eastern coastal provinces.
When looking at PetroChina in detail, you can model the exploration and production bit fine. You can model the petrochemical side as much as one can. But the refining business is the one that contains an unknown. You simply don't know how much money that business is going to make because the product prices are fixed, and in order to keep these refiners in business, the government effectively gives them a subsidy. There is a tax that exploration and production companies have to pay on oil production that goes toward paying the subsidy to the refiners, which keeps product prices at a reasonable level domestically. So, you have no idea how much of a subsidy the government is going to hand out -- that's what makes it a tricky business.
A: CNOOC I think is the more straightforward of the businesses, because it is producing oil offshore and we can make a financial model. We can say that 40% of it weighted to buy, 10% is taxes and the balance is from Indonesia. So you can create a pricing model and you can get very close to what Cnooc is going to earn. I still like PetroChina in spite of the fact it's a difficult one to model.
Fund Facts
Guinness Atkinson China & Hong Kong Fund (ICHKX)
| Assets: | $254.3 million |
| Expense Ratio: | 1.52% |
| Front Load: | None |
| Annual Portfolio Turnover: | 8.0% |
| Yield: | 0.96% |
____________________________________________
Top 10 Holdings
(as of Feb. 28, 2010)
| Yanzhou Coal Mining | (YZC) |
| Weichai Power | |
| Cnooc | (CEO) |
| BYD | |
| CNPC Hong Kong | |
| China Mobile | (CHL) |
| VTech Holdings | |
| PetroChina | (PTR) |
| Dongfang Electric | |
| iShares FTSE/Xinhua A50 China Index ETF |
Q: Let's move on to the Internet. I noticed that you have been adding to positions in Sohu.com (SOHU), NetEase.com (NTES) and Perfect World (PWRD). What do you like about them?
Q: All three of them are a great way of playing the growth in incomes, in youthful Chinese consumption. They are asset-like businesses. The Chinese love the Internet. The speed of takeoff has been phenomenal.
Instant messaging is taking off enormously, but these role-playing games, there are Internet cafes all over. All of them -- Sohu, NetEase and Perfect World -- are generating very good business from these online games with margins of 70% to 80%. The big costs for them are server and bandwidth leasing and the sum cost of the game, but basically after that, it is all profit. Perfect World has just launched, for example, a new upgrade to a game in October, and it is reckoned to account for about 10% of their revenue in the fourth quarter, which is a really quick take-up. There is so much demand for this kind of thing.
You've got a choice of how to play the consumption [story, such as] Chinese retailers, but retailing is a hard business. You will lose money if you've got your merchandising wrong. But take an online game maker trading on substantially lower price-to-earnings multiples and earning much higher margins with such strong cash flows. That makes a much less risky way of playing the Chinese consumption story.
Q: You've mentioned instant messaging. Is China Mobile (CHL) also a part of that consumption story?
A: It is kind of. It's a company that I'm a little bit more cautious on at the moment, and that's more to do with competitive pressures and the nature of what is a particular phase of development that the telecom industry is in, in China.
China Mobile is somewhat on the defensive. They've taken a 20% stake in Shanghai Pudong Development Bank, and that is to really allow them to move in to electronic bill paying, mobile bill paying and that sort of thing. But I think they feel that they have to offer more services to fend off the likes of China Telecom (CHA) and China Unicom Hong Kong (CHU) to try and lock in their existing subscriber base.
Q: Thanks.
Investment Philosophy
Harriss takes a top-down view on what is going on from a macro perspective, regarding money supply, interest rates and policy. He draws out investment themes from that and uses a bottom-up process to find the best stocks that offer the best value.
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