Hitching to China's Engine

China-U.S. Growth Fund's Daniel Chung and Zachary Karabell on companies that are poised to ride growth in this new powerhouse

The two big economies that are going to drive the global economy in the next few years are China and the U.S. So says Daniel C. Chung, president and chief investment officer of Fred Alger Management, who, along with Zachary Karabell, Fred Alger's senior economic analyst, run the China-U.S. Growth Fund. They see good opportunities in growth stocks.

The fund was launched last January to invest in a basket of companies all over the world that stand to benefit from the Chinese economy's dynamic growth, which they estimate at 7% to 9% a year. Chung and Karabell project above-average earnings growth for companies such as Yum Brands (YUM ), whose casual style of dining is taking off in China, and Wynn Resorts (WYNN ), which is about to open a casino in Macao.

Holdings of the fund are roughly 50% U.S. and 50% Asian -- from China, Hong Kong, Japan, and Korea. The Asian stocks are managed out of Hong Kong by JF International Management, a subsidiary of J.P. Morgan Chase (JPM ).

These were a few of the points made by Chung and Karabell in an investing chat presented July 22 by BusinessWeek Online on America Online, in response to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts follow. A full transcript is available from BusinessWeek Online on AOL, at keyword: BW Talk.

Q: First off, can you give us your snapshot view of what's going on in the stock markets right now?

A:

We think that political uncertainty, as well as geopolitical incertainty, has contributed to what we see as an unjustified sell-off in the market, given the strong corporate profits we've seen this year. About 30% of the Standard & Poor's 500-stock index has reported so far, and more than 70% of those have beaten earnings [estimates]. Only about 10% have missed earnings, and the S&P 500 earnings are up 22.5%. Fundamentally, the market is very strong, corporate profits are very strong, but the market has not acted accordingly. We're going to get a significant rally in the coming months.

Q: Microsoft (MSFT ) just reported results. What do you think of its plan to boost its dividend and buy back stock? Is Microsoft no longer considered a "growth" stock?

A:

I think Microsoft is a terrific stock and a great company. Right now, they're demonstrating real leadership, showing that the cash belongs to shareholders. The company will grow earnings, and also dividends, in the next three years. We love it -- it's our top holding [for the other Alger funds. Microsoft is not held in the U.S.-China Growth fund].

Investors seem to have forgotten that Microsoft really is an innovative company. For example, the Xbox is clearly the challenge to Sony (SNE ), Halo is one of the best-selling consumer-software games, and their collections of Web sites are doing very well even against Yahoo! (YHOO ), Google, and AOL (TWX ). I think Microsoft is still a growth company and is going to be a very good one that pays big dividends and continues to expand.

Q: Tell us a little about the concept behind the China-U.S. Growth Fund at Fred Alger Management.

A:

The concept is that China is going to be a driver of global economic growth for years. China itself will grow roughly 7% to 9% in its gross domestic product for the next several years. This will obviously change many sectors and have a profound impact on many companies. We saw a chance to benefit from this. Whichever companies have the right kind of vision to benefit from their growth, the right strategies, we're interested in.

A lot of people talk about the best way to invest in China and say the best way is to buy a China-only fund, but that doesn't reflect the best way to invest in China -- it's a global opportunity. We think there will be a lot of U.S. and multinational companies that could really benefit from China's growth, and we wanted a vehicle that could address those.

Q: What sector of China's dynamic economy is going unnoticed but ready for big gains in the coming months?

A:

We think that what's still underplayed is the consumer segment in China -- growing middle-class income in the coastal provinces of China...you have 100 million to 150 million middle-class consumers with a disposable income of $1,000 per year. These people, often young, will want to spend money on cell phones, games, clothing, restaurants, and other such things.

Q: What should we buy?

A:

You should buy companies that are seeing above-average potential earnings growth from the China market...Yum Brands (YUM ) is interesting, because the concept is a little more casual dining, vs. fast food. Yum Brands recognized the opportunity there. It's the fastest-growing part of their business.

Wynn Resorts (WYNN ) is going to open up a branch there. The new resort in Macao will capitalize on the lack of competition in the area. Chinese consumers have the money and the time and interest in gambling to make this company do well.

Teekay Shipping (TK ) is also doing well. China's demand for energy, given the rolling blackouts last year, is going to be huge. Teekay Shipping is the biggest shipper of oil.

Anheuser-Busch (BUD ) owns Harbin brewery and is bidding on Tsingtao, and they stand to grow very well. Their farsighted management team is setting them up very well. They have about a 30% to 40% market share in the region. Those are just some examples -- they're all in the current portfolios.

Q: How do you measure a company for the fund? Does it have to get a certain amount of sales from China?

A:

We don't have a specific percentage of sales that a company has to get from China, but in principle they have to be deriving some strategic benefit from China. An interesting example is UCBH Holdings (UCBH ). It's based in San Francisco. They don't technically have many revenues in China at all, but they're a facilitator for Asia-U.S. business.

Q: How about Internet opportunities in China?

A:

We think the Internet stocks are interesting. We were big Internet investors in their heyday. The Chinese model is very interesting because of the problem of income. Most Chinese do not have broadband, but Internet cafes are huge. The other big problem in China is software piracy. Development of the software market will suffer, and many of the Internet companies in China have decided to go with the prepay or pay-as-you-go models. They deliver software online rather than on a disk where it can be pirated.

Online gaming and messaging are huge. Gaming is interesting to us. It has been slow to take off in the U.S. There are some early leaders there -- NetEase (NTES ), for example -- though the messaging business has been slow because of the telecom companies' big role (charging for transmission). So owning a small basket of Chinese Internet stocks could be a very good thing. Tom Online (TOMO ) and Sina.com (SINA ) are also good ones to watch as two other online leaders right now. It's going to be extraordinarily volatile, though.

Q: How do the fund's holdings break down as to country of origin for the companies?

A:

The holdings are roughly 50% U.S. and roughly 50% Asian -- Hong Kong, China, Japan, and some Korean. But it's roughly 50-50. One of the advantages of our product, we think, is that we're working in partnership with JF International Management [in Hong Kong, now a subsidiary of J.P. Morgan Chase (JPM )]. The guys there are our partners in this: They run the Asian side. What we're doing in here, basically, is in a single product we think we're one of the best in U.S. equities, and JF's one of the best in Asian equities.

Q: Do you own any stocks betting on growth in infrastructure in China -- commodity or energy plays?

A:

Most of the best plays there are in Asia...One that is U.S.-traded is United Technologies (UTX ), with its subsidiary Otis. They're doing residential construction in Shanghai -- all of these gleaming new high-rises, with booming housing prices going on there. All of these buildings need elevators. In the past few months, we've decreased our exposure to these kinds of companies (the Chinese ones, at least) because of the slowdown of industrial construction in China, which has been government-mandated.... The fund in the beginning of the year had large exposure in that area.

JF reduced our weighting there after the government's mandate, but there are good plays there. You just need to buy and sell the stocks there at the right prices. Just to throw in one on the American side, there's a company that has a huge position in China, Archer-Daniels-Midland (ADM ), which has had 50% international growth, even higher in China.

Q: Do you detect any problems with corporate governance and regulators affecting business in China?

A:

There's been a lot of action from the Chinese security regulators -- they want greater transparency, a higher level of accounting standards -- but the one thing that's most striking is that as more Chinese look to foreign markets and investors, the act of doing that is forcing them to raise their accounting standards.... If I had to give them a grade, it'd be a C -- it used to be a D. It's bad, but getting better, and that's one of the risks of investing there.

Q: Which technology companies do you own in the fund, besides Microsoft?

A:

We also own PalmSource (PSRC ), the operating system for all Palm devices, including the smart phone they make. Basically, we think the whole cell-phone market is going to go toward smart phones that combine voice, e-mail, and other digital functions. We think we're going to see a lot of licenses with competing smart-phone manufacturers like Samsung. So that's a nice play...We also own Qualcomm (QCOM )...they've come up quite a bit, so I might not recommend buying them right now, but we do like it long-term. That would be a "buy on pullback," I guess.

What people shouldn't miss is that the two big economies that are going to drive the global economy in the next few years are China and the U.S.... We think the opportunity in the U.S. is growth stocks.

Edited by Jack Dierdorff

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