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Guinness Atkinson Asia Brief

November 2004
Edmund Harriss
Fund Manager Asia Focus Fund, China & Hong Kong Fund

Economy

China’s economy has steadied after the breakneck rate of growth at the end of last year and the beginning of 2004. Fixed asset investment growth is still high and a concern but has fallen to 27%. At the same time, loans are growing 13.6% compared to 24% a year ago while money supply is now growing at 14%, down from over 20% last year. All of these indicators are now well within the government’s comfort zone and all growth rates have been easing back at a measured pace. This is a far cry from the fears of a crash that dominated headline earlier this year.

More importantly, while the overheated sectors have cooled, consumer spending has accelerated and exports remain strong expanding at an annual rate of 33%. It was a crucial part of the government’s plan that administrative measures would target excesses in the economy while leaving the major motors of consumption and exports untouched, to the up the slack. This is also important to investors since these sectors are the key areas where we look to put our money.

Many challenges remain, but with the economy having grown 9.5% in the first nine months of 2004, we expect to see growth of 9-9.5% for the full year. In 2005, we expect to see slower GDP growth of 8%. Crucially however, this slower growth will be at the expense mostly of activity with doubtful value, and not at the expense of the productive areas of the economy in which we invest.

New Developments

At the end of October, China raised interest rates for the first time in nine years. The rise was mild across both lending and deposit rates, with the benchmark one-year lending rate up to 5.58% from 5.31% but it is important as a statement of intent. Firstly, short-term deposit rates up to six months did not change at all so not to affect the growth in consumer spending as well as to discourage flows of ‘hot money’. Secondly, it is also a first step toward shifting from an administrative to a market-based approach to managing economic policy. Ultimately, this approach will lead to full liberalization including that of the currency, although this last is still some way in the future.

The conclusions that we draw from all this are firstly, that it appears China’s economy is more sophisticated, broader based and more stable than many have appreciated; and secondly, the very successful actions by Chinese policymakers have put the economy on a much more sustainable growth path. The move in interest rates and the willingness to consider exchange rate flexibility also gives us a clearer glimpse of where we go from here.

Stock Markets & Prospects

China shares listed in Hong Kong, including H shares, Red Chips and China plays have picked up since August. Hong Kong, too, has seen its market rise as property prices have recovered and visitors from the Mainland have boosted retail sales.

Our confidence in future prospects stems from the economic progress we have already discussed, together with the improvements in corporate management and governance. This has translated into improved profitability as can be seen in the steadily improving operating margins in the last 5 years from 15.5% to 19%. Capital investment, which had previously driven growth, has declined as a proportion of sales from 13.5% to 7% and business efficiency together with better products have taken its place as the key drivers. A final indicator is the increased dividend payout. In 1999 the 30 companies covered by UBS paid out just 7.9% of their profits. In 2003 this had risen to 35.4%.

China & Hong Kong Fund (ICHKX)

The Fund remains tilted decisively toward China rather than Hong Kong, in spite of the latter’s improving economic situation, because we see China’s growth as more stable than many have given it credit; consequently, we believe that the growth is undervalued. In the first nine months of the 2004 H shares fell 7% against a 38% upward revision in earnings. This implies a de-rating of 34% and as we have seen, with the economy running as well as it is, this is probably not justified.

The portfolio breakdown as at the end of October was:

The Fund was trading on an estimated Price to Earnings multiple of 11.63x 2004 forecast earnings and 10.25 times 2005 forecast earnings. The earnings growth for the portfolio based on market consensus estimates is 19.9% in 2004 and 13.5% in 2005.

Edmund Harriss
November 11 2004

The Guinness Atkinson China & Hong Kong Fund invests in foreign securities which will involve greater volatility, political, economic and currency risks and differences in accounting methods. The Fund is non-diversified meaning it concentrate its assets in fewer holdings than diversified funds. Therefore, this Fund is more exposed to individual stock volatility than diversified funds.

The Fund’s industry sector weightings and geographic weightings may change at any time due to ongoing portfolio management. References to specific investments and weightings should not be construed as a recommendation by the Fund or Guinness Atkinson Asset Management, LLC to buy or sell the securities.

Price to earnings ratio is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share.

This information is authorized for use when preceded or accompanied by a prospectus for the Guinness Atkinson China & Hong Kong Fund. The prospectus contains more complete information, including investment objectives, risks, fees and expenses related to an ongoing investment in the Fund. Please read the prospectus carefully before investing. Mutual fund investing involves risk and loss of principal is possible.

Distributed by Quasar Distributors, LLC (11/04).

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