Is it too late to cash in on China’s economic boom? If the recent performance of the MSCI China free total return index, the benchmark that tracks the stocks of mainland companies listed in Hong Kong, is anything to go by, that may indeed be the case.

The index shot up 16% last year, leaving Chinese stocks looking expensive. However, at least one fund manager interested in China as an investment destination thinks the country’s potential has barely been tapped.

Stephen Way, a senior vice president at Toronto-based AGF Funds Inc. and head of its global equity team, says making a China play is slowly becoming simpler. The $136-million AGF China Focus Class Fund, which buys shares of companies operating in China, Hong Kong and Taiwan, climbed a modest 8.3% in 2005, but Way is counting on better times ahead.

“The economy is still on the move, with roughly 8% growth and a steady rise in per capita income,” he says. “However, economic growth doesn’t always translate into great stock performance.”

One issue is the expectation that China’s currency may eventually be revalued upward again to reflect the country’s outstanding success as an exporter. This is good news for North American companies, as any revaluation will cause Chinese imports to become slightly more expensive, but it will affect Chinese export prospects.

Last year’s minor shake-up of the way the yuan is valued was “clearly more symbolic than anything else,” Way says, pointing out that Chinese authorities will be careful not to move the currency’s value too quickly as this could destabilize the country’s export market and the huge capital investments made by Western firms. “This story is still unfolding,” he adds.

Against this backdrop, the fund has done quite well over the longer term. Although it lagged a bit last year, it produced a first-quartile average annual compound return of 9.4% for the five years ended March 31, 2006, significantly eclipsing the MSCI benchmark’s return of 3.9% over the same period — all the while fighting the headwind from the soaring Canadian dollar.

Way credits the fund’s performance to a patient investment style that is focused on investing in companies that will be well positioned in the next three to five years instead of the next few months. Nomura Asset Management Co. Ltd. , which handles the on-the-ground decisions in the region, normally holds a stock for a minimum of three years, he says, sometimes raising or lowering its weighting in the portfolio depending on shorter-term valuations. Cash is normally kept in the 5% range.

The portfolio, which consists primarily of larger-cap stocks, is quite diversified, even though Nomura has historically overweighted the consumer, financial and resources sectors, Way says. Right now, the fund’s top four positions are in energy (27.6% of assets), financials (15.9%), telecom (14.8%) and consumer issues (14.5%).

Because of restrictions on foreign ownership of stocks and concerns about government involvement in the shares of the mainland China exchanges, AGF China Focus managers are most interested in the so- called “red-chips” — Hong Kong-based companies in which mainland China businesses are significant shareholders.

Many overseas investors are still leery about investing directly in mainland China companies, and Way is certainly one of them.

“There are still some very real issues with regards to governance and disclosure, but things are certainly improving, albeit slowly,” he says.

The recent inclusion of several additional China-based companies in Hong Kong’s Hang Seng index will make it even easier for overseas investors to buy these stocks, Way believes, and it will make the Hong Kong market that much more correlated to the Chinese economy.

To tap that economy, Way has identified four major areas in which to concentrate: resources, infrastructure, domestic consumption and exports.

Focusing first on firms dealing in commodities — the essential raw materials for China’s fast-growing industries — is the way to go, he advises. Consequently, the fund has invested heavily in BP PetroChina Petroleum Co. Ltd. and China Petroleum & Chemical Corp., both of which make petrochemicals and drills for oil and gas production. China National Offshore Oil Corp., a joint venture with Shell Petrochemicals Co. Ltd., is another key holding.

China’s steel industry — which is closely linked to large-scale developments, especially those associated with major events such as the 2008 Beijing Summer Olympic Games — is also worth watching. For the past few years, China’s steel consumption has been growing faster than even its economy because of the rapid pace of industrialization. And, because almost 70% of the country’s steel supply is used directly or indirectly in construction, the high growth of expenditures in infrastructure will translate into more opportunities.

@page_break@In the short term, construction of Olympic venues and related facilities will translate into tens of thousands of extra jobs in the construction sector, he says. But employment may shrink when construction of these projects draws to an end. For this reason, Way sees infrastructure plays being balanced by consumer-driven stocks as income levels in major cities climb.

But even though China’s urban economy has been growing by double digits, the pace of urbanization has been no faster than that of slower-growing India. But it is picking up. And the migration of rural labour has a double benefit: it reduces the farm population and creates a stream of income back to the rural areas, gradually increasing the demand for goods.

For this reason, Way recommends companies whose growth is being fuelled by these consumers, such as rebounding China Mobile Communications Corp., the dominant operator that holds the majority of subscribers in this marketplace, and BOC Hong Kong (Holdings) Ltd., a wholly owned subsidiary of Bank of China.

A recent addition to the portfolio is Swire Pacific Ltd. With its diversified interests in large-scale residential and commercial properties, aviation, marine services and the production of a wide range of beverages, Swire is also poised to tap into China’s growing demand for consumer goods.

However, investors must be aware that the stocks of Chinese companies have undeniable political and economic risk, Way says.

Reports abound that the Beijing government interferes in listed companies’ strategies, and that its courts often appear reluctant to enforce contracts.

However, he believes that these concerns are already reflected in the discounted stock prices. In the longer term, he sees the Chinese government “slowly swinging toward a more free-market stance,” with no significant pullback.

The extensive travel that comes with overseeing a market such as China is nothing new for the 44-year-old Way, who joined AGF Funds some 20 years ago, initially as a client-service representative. After a stint as a U.S. equity analyst, he moved to Dublin in 1991 to set up AGF’s European office, receiving his chartered financial analyst designation at the same time.

He moved back to Canada in 1994, where he helped to launch AGF China Focus Class Fund.

He also assumed the management duties for several AGF global funds after the firm dropped Rothschild Asset Management Ltd. as fund manager because of poor returns. Way’s subsequent makeover left those funds holding much more significant weightings in emerging markets than they did under Rothschild.

Way says that one of the reasons why he is attracted to emerging markets is because, contrary to the popular perception, he believes that these markets are actually low-risk because of the significant opportunities they have for great returns. As a result, his global funds still hold below-index weightings in the U.S. and continental Europe, and they are tilted more toward Japan.

“Obviously, a sector fund such as China Focus is centred on one region,” he says. “Overall, however, I believe that investors here now need to look beyond North America more than ever.”

Nevertheless, Way says, investors would be wise to approach emerging markets with caution. “This area should continue to do well,” he says, “but it can be volatile. And most investors probably should not invest more than 10%-15% of their portfolios in funds of this kind.” IE