The $111.0-million fund has no market cap restrictions. However, out of concern for liquidity, Harriss avoids companies valued at less than U.S. $200 million in market cap, as well as positions that require more than five days to sell. Nonetheless, the fund's turnover is markedly lower than its peers. In addition, its expense ratio of 1.81% compares favorably with 2.22% for its peers.
With just 44 stocks in eight sectors, the Guinness Atkinson China & Hong Kong fund is not only country specific, which courts greater risks, but relatively concentrated. "There's only so much diversification that adds value," Harriss says. "If I want a car company, I'll hold one -- not two or three." A portfolio of this size is meant to track and to watch the stocks "likely to cause problems," he says.
The fund has done a good job of offering investors exposure to China with solid long-term returns while roughly matching its peers in volatility. For the three years ended in December, Guinness Atkinson China & Hong Kong fund returned 17.3% annualized, versus an average gain of 15.1% for its peers. For the ten-year period, it holds the No. 1 position among China funds, returning 7.7% annualized, versus 2.0% for its peers. The portfolio carries a 4-Star rank from Standard & Poor's.
Harriss has been the fund's lead manager since April 1998, when he lived in Hong Kong. Since 2003, he's been in based in London. Timothy Guinness joined him as co-manager that April. As of Dec. 31, 2004, Hong Kong shares represented 35.9% of fund's assets; H Shares were 23.7%; China Plays, 19.5%; Red Chips, 18.3%; and cash, 2.6%. The categories are defined further below.
The Full Interview:
S&P: How would you describe your investment strategy?
HARRISS: I'm looking for capital growth using a bottom-up stock-specific approach. I see share prices being driven by four factors, and I build my portfolio accordingly, believing that more positions will work out than won't.
S&P: Are you concerned about holding shares in companies owned by the Chinese government?
HARRISS: No. In any Chinese company, the government is likely to have a stake -- particularly with the H shares and in key areas such as oil, telecommunications, and power. The government doesn't necessarily exercise management control day to day, and the companies are reasonably transparent. You have to look at their track records.
I'm more concerned about the alignment of interests between managers, shareholders, and parent company. When the parent starts fiddling around, it is a recipe for losing money, and stock prices take a hit. I am also cautious about large IPOs by companies without track records.
S&P: What is your view on the political risk of investing in China?
HARRISS: In China it is lessening, although Taiwan is a wild card. I think China's commitment to private ownership and the market economy is unquestioned. However, there can be sudden or capricious change in government policy or the competitive environment.
S&P: What are your buy criteria for stocks?
HARRISS: We have four: quality, measured by return on investment; value; positive earnings revisions; and technical analysis of short- and medium-term share price. While none of these likely drives the share price by itself, I believe that together they do in the medium term.
S&P: How long do you usually hold stocks?
HARRISS: As long as the four criteria hold together. Esprit Holdings Ltd. has been in the portfolio for five years, and HSBC Holdings plc since the fund started in 1994. The turnover of 30% means the average holding period is about three years.
I'm prepared to let a stock run even though it may be expensive on a P/E basis. But if analysts start to downgrade its earnings forecasts, it's practically impossible for a stock to outperform.
S&P: How do you decide which stocks to buy?
HARRISS: I rank the 200 stock universe in terms of our four criteria, and conduct due diligence on the top 20 stocks. The best a company can score is 40; the worst is two.
I analyze where returns come from, look at working capital, and build P&L balance sheets and cash flow models to conduct sensitivity analyses. To get a valuation, I look at discounted cash flow as well as price/earnings and price/book multiples. Chinese companies typically sell for around 11 times earnings; Hong Kong companies, 16.5.
S&P: You mentioned H Shares. What other kinds of shares can the fund hold?
HARRISS: The fund can hold A and B shares --- those listed and traded in Mainland China -- but at the moment doesn't have any. Those companies are usually at very early stages of development and trade at high valuations because domestic investors have nowhere else to go.
S&P: Do you ever take a contrarian view when it comes to stock selection?
HARRISS: I rarely take a contrarian view. If the market generally is revising down its expectations for a stock, I am not going to buy it. With this portfolio, I'm trying to get it more right than wrong.
I'm interested in what the market in aggregate thinks, its expectations for earnings revisions and the dispersion of those estimates. But we have to establish whether the market is correct and trends are sustainable.
S&P: How are the fund's assets allocated?
HARRISS: The biggest sector weighting at 19.7% is in industrials. About 15% is in resources; 14.5% is in consumer stocks -- auto manufacturers, food, clothing retail; 14.3% in services -- telecommunications, port operations; 11.6% in financials; 9.1% in conglomerates, which includes companies like Hutchison Whampoa Ltd. and Swire Pacific Ltd.; 7.0% in utilities; and 3.4% in Hong Kong real estate. Generally, I maintain no more than 3% cash.
S&P: Are there any sectors that you avoid?
HARRISS: I usually avoid real estate in Hong Kong and China. I added Midland Realty (Holdings) Ltd., a property agent, last year. But a full sector holding would be 12%-13%.
I'm moving away from midstream industrial materials -- petrochemicals, steel, cement. Although China has a structural demand for basic commodities like oil, copper, aluminum, margins will be compressed in the midstream area due to higher raw materials prices and capacity increases.
S&P: How do you manage or hedge currency risk?
HARRISS: I don't take currency positions. The Hong Kong dollar and the renminbi are pegged to the U.S. dollar. If the renminbi is revalued, it will not make much of a difference -- Chinese goods will remain cheap. The Hong Kong dollar is not going to de-peg.
S&P: Have your holdings changed in the last year?
HARRISS: Very little -- I'm not a fiddler. High turnover creates friction costs and tax implications. In these volatile markets, trading is not necessarily the way forward.
S&P: What would make you sell a stock?
HARRISS: When people are marking down future earnings estimates, it's the first sign that things are not going so well. Once the four buy criteria start to break down, it's time to leave.
S&P: Could you single out one or two top holdings and tell me how they reflect your investment style?
HARRISS: Techtronic Industries Co. Ltd. (7.1% at year-end 2004), and Esprit (7.22%), are both are high-return businesses with improving margins. For Techtronic, it's due to relocation of production facilities; for Esprit, skill in merchandising and materials sourcing. Both are significant players in key areas, and their working capital is well managed. Earnings estimates have remained relentlessly positive.
S&P: What differentiates your fund from others?
HARRISS: If you buy a China index like the iShares MSCI Hong Kong Index, you get telecommunications and oil companies in spades. The Barclays ETF caps some of those stocks, but its holdings in China Mobile (Hong Kong) Ltd. are about 9%, versus the index's 20%. I hold 3%-4%. So with our actively managed portfolio, I skew the holdings the way I want to. Also, our benchmark is the Hang Seng Composite Index, a broader universe than the MSCI.
As far as Matthews China Fund (MCHFX) goes, we're doing basically the same job: actively managing the same universe of stocks.
S&P: Do you meet with management in China?
HARRISS: I haven't been to China for the past year, but managers come to London. I met many of them when I lived in Hong Kong from 1998 to 2003. They're reasonably forthcoming. One has to accept that they are going to put the best spin on things. Nevertheless, they will talk about where the problems are.
S&P: Do you expect China's economy to slow?
HARRISS: Fixed investment and construction will both slow this year. But if this reduces foreign investment, it won't make much of a difference to the overall picture. Foreign investment accounts for about 9% -- $60 billion -- of China's total investment activity.
China's exports will not grow as fast this year as last year. Trade growth started slowing at the end of last year, but is expected to pick up in the second half of 2005. We will almost certainly get another rise in interest rates, but inflation should remain low.
Overall, I'm not expecting any great surprises. I think China's economic growth will drop from about 9.1% to 8-1/2%, and corporate earnings will rise about 8%.
Asia appears more stable than it has in a long time, with record foreign reserves, a current account surplus, low foreign debt and inflation, and currencies with a bias to appreciate. The risks are that U.S. consumption collapses; energy prices shoot up and stay there; and investment suddenly takes off again, forcing Chinese authorities to slam on the brakes. At the moment these risks look pretty remote.
S&P: What kind of investor should buy your fund?
HARRISS: Investors should be reasonably sophisticated and understand the market's volatility. One rule of thumb says that China's economy, at about $1.4 trillion, represents 5% of the global economy. So putting 5% of your assets in a China fund seems to make sense.
This should be a longer-term investment that the investor can choose when to withdraw money, rather than having to liquidate while China's having a wobble.
Contact Bob Keane with questions or comments at: email@example.com.