The Big Picture for the Week of December 25, 2011

In my 2012 outlook piece for Seeking Alpha and in the upcoming 2012 Roundtable for Bespoke Investments I have some positive things to say about investing in China. As the chart below shows, investing in China has been rough for the last few years. Since the 2007 high for the S&P 500 the Shanghai Composite is down about 60% and the Hang Seng is down about 30%.

One thing that is true in general terms is that markets can correct in time not just price. After four years of going down in fits and spurts it is possible that the China markets are now ready to go up. We can explore this a little further in this post and you can draw your own conclusion but correcting in time is not an outlier phenomenon.

In mid 2007 we sold out of Sinopec (SNP) and a little over a year later went into China Mobile (CHL). SNP was a great hold, I became wary and moved into a less volatile name with CHL but that was a mediocre hold at best and we sold it. After having no China exposure for a while we added an underweight by virtue of China's weight in Market Vectors Coal (KOL) and iShares Emerging Market Infrastructure (EMIF)--our China weighting is about 1% by way of these funds.

The negative argument for investing in China surrounds anything to do with real estate, over capacity, empty cities, debt loads of the banks and debt loads of the municipalities which contributes to questions about whether China will be in for some sort of hard landing. There are also concerns about demographics. GDP growth has been 9-10% for a long time and I have seen several different definitions of what would constitute a hard landing but many believe that if there is a hard landing in China there would be serious social unrest.

The positive argument centers around urban migration, ascending middle class (an "American-ish" lifestyle), China playing an ever increasing role in the world economic order and the country continually becoming wealthier.

I don't think there has been much change to either side of the ledger in quite a while. I think the same threats will continue to threaten for a while longer and the same positives will continue to be the positives for a while longer. I think the decision about what to do with China boils down to a combination of how long the China market has been slogging on and which of the two sides will win out from here.

As you know there has been a lot of commentary about how bad things might get in China because of the various things mentioned above along with other reasons. The reasons are valid but it is also true that the market has fallen by 60% in four years and while it is of course true that it could fall another 60% from here I believe the decline thus far discounts a lot of problems.

China is not facing the systemic threats that the US and Europe are facing yet it is down more than these markets, I looked at Germany, France, Spain, Belgium and Italy (Italy is down about the same as Shanghai) in this context in the last four years. I think this is saying that China is over done, Europe has a lot farther to fall or both.

If you can buy into the idea that China is not facing systemic threats then it is a cyclical event and a cyclical events tend not to last this long. A 60% decline more than prices in a cyclical recession in my opinion. And if a recession of some sort is what is coming then it is plausible that since equities turned down so long ago that they could turn up before a recovery starts and in this instance maybe even before the hard landing. Again, you can agree or disagree.

About that hard landing, although merely anecdotal China is still doing a lot of buying of resources around the world with the latest news being this week that Yanzhou Coal (YZC) is buying Australia's Gloucester Coal (GCRLF).

For many years I have been saying I want no part of the banks or real estate companies, and for that matter I don't want to own companies that rely on discretionary purchases of Chinese trade partners. I'm not changing my opinion on that so this rules out many of the ETFs that exist for investing in China.

For me the story has not changed, it has simply evolved. I don't like the banks and RE companies and haven't for a long time, that has not changed but the story in terms of what appears to be going on with lending and overcapacity continues to play out. Likewise demand for energy, resources (although resources are in part tied to the overcapacity) and something close to the American lifestyle continues to increase. This demand creates a tailwind as I often say, that has not necessarily mattered lately but it is the starting point for an investment thesis.

I think energy can be owned, but not solar, also industrials and utilities. For consumer I would avoid exporters and focus consumer items made in China for Chinese people but to be clear I favor the other sectors mentioned. I will be looking to add a little more Chinese exposure probably with one stock at 2-3% which obviously would take the total exposure to 3-4%.

One point of clarification is I am not talking about reverse mergers or companies that otherwise domicile in China but list primarily in the US.

Obviously you may weigh out the positives and negatives and conclude it is still something to be avoided but if you have ever had some interest in China and think that you might in the future then you do need keep tabs on current events and reassess these various factors every so often because if I am wrong about China in the near term, then it will be a buy at some other point.

Merry Christmas.