After riding a rocket for two years, Chinese stocks have fizzled amid fears of a slowing U.S. economy and worries that global growth, and China’s, will decelerate.

Indeed, the benchmark Hang Seng total return index, which includes many Chinese companies, is down about 12% year-to-date. The decline began in late October, when the index peaked at 31,450 points; the index was recently at 23,450, a drop of about 25%.

This volatility is familiar to Kingston Lee, manager of the $461.1-million AGF China Focus Class, the oldest and largest Chinese equity fund in Canada, offered by Toronto-based AGF Funds Inc.

“The index bottomed in 2003, at about 10,000 points,” says Lee, chief portfolio manager at Hong Kong-based Nomura Asset Management Co. Ltd. “Then it peaked in 2007 and had gone up 200%. It’s very reasonable to expect a correction — maybe half of the gains — and [see the index] fall to about 20,000 points.”

Lee argues that the market’s volatility is similar to the up-and-down pattern in the price of crude oil. It was around US$20 a barrel in 1999, rose to US$50 in 2005 and hit US$100 in 2007. It has settled at around US$90 a barrel.

“Uptrends depend on the fundamentals,” Lee notes. “The key issue is: what is our view on economic growth in China? So far, I haven’t seen any analysts or economists forecasting that China will go into a recession. Our firm is forecasting 9.7% GDP growth for 2008, which is quite a decent level of growth.”

Although Chinese exports to the U.S. are declining, exports to other parts of Asia and Europe are robust and growing. Another key indicator: China’s retail sales are very strong and growing by 16%-18% a year.

If investors have the view that China will continue to grow at a reasonably high pace, there is every reason to expect the market will go higher over the long term, says Lee. Still, market corrections are an inevitable part of the process.

“That provides us with an opportunity,” says Lee. “Look at oil prices. They corrected, and later surpassed the previous peak.”

Lee espouses a long-term view, reflected in the fund’s relatively low turnover — 40.5% in the year ended Sept. 30, 2007, and 28.9% in the year ended Sept. 30, 2006. Although Lee took over the portfolio in March 2007, the fund had been managed consistently in the same fashion by a team of Nomura managers since its inception in April 1994. The consistency of approach and emphasis on blue-chip stocks have contributed to the fund’s performance. For the year ended Dec. 31, 2007, it returned 30.5%. Over three-, five- and 10-year periods, it reported average annual compound returns of 33.4%, 28.6% and 14.8%, respectively.

For the five-year period, AGF China Focus was the top fund in a group of three Chinese funds. On a three-year basis, it ranked third among six funds.

Like the overall stock market, the fund’s performance has not been straight up. In 13 calendar years, there were seven “up” years and six that were down, acknowledges Steve Way, AGF’s senior vice president of equities, who oversees the fund from Toronto.

“China is a great place to invest. But it can also be volatile — especially the past two years, when the fund was up 68% in 2006 and 31% in 2007,” says Way. “Nobody would be surprised to see a negative return in the future. That’s what investors have to recognize. It should be part of a diversified portfolio, and clients have to have a longer-term horizon to deal with the volatility.”

Lee, who works within a seven-person team, devotes about 30% of his time analysing top-down issues such as global macroeconomic trends and industry developments. The other 70% of his time is spent studying stocks based on their fundamentals, such as valuations, earnings per share growth trends and management track records. Stocks are then rated on a scale of one to four. A stock that gets a “one” is considered a best buy, “two” is above average, “three” is marginally attractive and a “four” is not suitable.

Importantly, the process is a collaborative one, as all team members have to agree to the acquisition or divestiture of a security.

“Across all our portfolios, we buy only one- or two-rated stocks, and only occasionally three-rated stocks. There is a lot of consistency in the portfolios,” says Lee. “We try to find truly outstanding stocks that can outperform. Most of us here have more than 10 years’ industry experience, and we visit up to 12 companies a month. We have some ideas [of] which stocks will do better and consult with each other quite frequently.”

@page_break@ The team’s primary objective is to beat the peer group of seven funds over the mid- to long term.

The fund is concentrated, with the top 15 names accounting for 70% of the portfolio. However, this is consistent with the weightings in the Hang Seng index, says Lee, noting the index has a similar concentration.

“We own a lot of high-quality names and don’t take excessive bets,” he says, adding that even if a company such as China Mobile Ltd. accounts for 20% of the MSCI China index (another common benchmark), he will limit exposure to 10% for a single stock.

One of the largest holdings of the fund is China Life Insurance Co. Ltd., the dominant life insurer in China. “We like the sector because penetration is less than 5%,” says Lee. “If you use other countries as indicators, you could see growth of 20%-30% a year for the next five to 10 years.”

China Life has the largest network of sales representatives and is the best-known brand in the country. It is also benefiting from demographic trends, in the form of a growing middle class, and high savings rates. Bought during the IPO in 2004, the stock has risen sixfold to HK$30 a share. Lee has no stated target.

Another top position is Industrial & Commercial Bank of China. “It’s one of the leading banks in China and offers a slew of services,” says Lee. “It is very well managed. It’s also the training ground for the other banks in China.”

The bank boasts 30%-plus growth. Its stock, which has a dividend yield of 4%, recently traded at 13.6 times earnings. Bought during the IPO in October 2006 at around HK$3 a share, the stock was trading recently at HK$17.

A Hong Kong native, Lee began his career as an auditor in Hong Kong, largely because there were few opportunities in the money-management industry. After graduating in 1983 with a bachelor of social science degree from the University of Hong Kong, he articled as an accountant at Arthur Andersen. Between 1989 and 1992, Lee lived in Toronto, working as an auditor with Royal Bank of Canada. During that period, he earned his chartered financial analyst accreditation. “I believed a fund manager’s job is more dynamic,” he says. “That’s the reason I decided to follow that path.”

In 1992, Lee returned to Hong Kong and was hired as an analyst by Schroders Investments Hong Kong Ltd. Over the next decade, he rose to portfolio manager and director. In 2002, he switched to the “sell” side when he joined ING Asia Ltd. as director of Hong Kong/China equity research. Lee then joined Nomura in 2004 as senior portfolio manager, subsequently becoming director of investments. In 2006, he was promoted to chief portfolio manager. Nomura manages about US$500 million for AGF.

Lee is bullish on the outlook for stocks. He notes that stocks on the Hang Seng index are attractive and were recently trading at 15 times earnings for 2008, compared with 16.6 for 2007. In addition, the drop in interest rates in the U.S. has caused rates to fall in Hong Kong, because the HK dollar is pegged to the U.S. dollar.

“Real interest rates are approaching negative territory and should help stimulate growth,” he says. “Hong Kong is benefiting from having a monetary policy tied to the U.S., but it is linked to an economic environment tied to China.”

Lee believes that in the near term, timing will be quite important in taking positions. “We are long-term positive on China,” he says. “But we also expect corrections could be fast and deep, because of concerns about the subprime issue in the U.S. Our strategy is not to be just buy-and-hold, but more tactical.”

Way agrees: China’s economic fundamentals remain strong; unemployment is generally low and capital spending is robust.

“The renminbi is likely to continue its course of gradual appreciation that we’ve seen in the past couple of years,” Way says. “Although a slowdown in the U.S. will be negative for Chinese exports, it will be offset by growth elsewhere.”

Moreover, Way stresses, inves-tors are getting in on the ground floor; China’s economy is where Japan’s or South Korea’s were decades ago.

“Considerable wealth was created in those capital markets over the long run,” he says. “Though there may be volatility in the short run [in China], the longer-term opportunity is quite significant as per-capita GDP continues to expand.”

Although the AGF China fund has delivered strong numbers, Gordon Pape, analyst and publisher of the Internet Wealth Builder in Toronto, recommends it only for non-registered accounts because of its high volatility: “If you rush to sell when markets are down, at least you can claim a loss if the fund is outside an RRSP.”

Even so, Pape doesn’t believe in making single country or sector bets, and suggests investors are wiser to own a global or international equity fund that has a significant Asian weighting.

Ranga Chand, analyst and president of Ottawa-based Chand Carmichael & Co. Ltd. , takes a more positive view of the AGF fund. He likes the fact that it has a long history and two-thirds of the time it made money in every five-year rolling period and has always made money in every 10-year rolling period.

“China is a growth story, and it will do well for the next few years,” says Chand, adding that a small position could be beneficial but advisors should check beforehand if clients have exposure to China in global or international funds.

“If your client is investing today and has a 10-year time frame, I’d say, ‘Yes, go right ahead’,” says Chand. “Because the time horizon is long, history shows that returns are positive over a long period.” IE