Is China a bargain or a bubble?

The country's economy is growing rapidly, which is good and bad news. Simon Read reports

David Cameron's jaunt to China last week came amid fears that the region could turn out to be a huge bubble.

The Prime Minister led the Government's largest delegation to China, with five cabinet ministers and 50 British business people aiming to forge closer links with the world's fastest-growing economy.

Investors have been backing China's growth for some time, and popular sentiment peaked in April when fund management firm Fidelity launched Anthony Bolton's China Special Situations fund to huge investor interest. Demand has been so strong that the firm plans to issue more shares in the investment trust in January.

Since launching seven months ago, the share has increased from its issue price of 100p to 128.7p last week. But more interesting than this is the fact that by 8 November, shares were trading at a premium to the net asset value (NAV) of 9.67 per cent. It is partly for this reason that new shares in the trust will be issued, which should bring down that premium.

When investment trusts trade at a premium to the NAV it means that anyone buying shares is paying more than the value of the underlying investments. The fact that investors are apparently queuing up to buy into China Special Situations shows how popular the country remains.

But buying into the Fidelity fund now could be a mistake, warns Stuart Fowler, the director of investment at wealth manager No Monkey Business. "If valuations count more than the story, investors are likely to be disappointed, even if the economy itself avoids implosion and companies achieve the growth rates that are expected," he says. "We are seeing a diluted version of the situation back in 2007, when the Chinese market was priced at about six times the book value of its listed companies. But that is also why the market is still nearly 40 per cent below the 2007 peak.

"That it is up about 130 per cent since the bear market low does not conceal the reality that, in stock market terms, China has already imploded. Rational valuations are sitting like a dead weight on the hopes of a still-growing band of retail investors around the world who believe the China growth story."

David Coombs, the head of multi-asset investments at Rathbone Unit Trust Management, warns that Western money is being sucked in and not necessarily finding a smart home.

"Investors are increasingly looking East for growth on the promise of super-normal returns, but there are many 'tank traps' awaiting them, dangers that the numbers simply cannot and do not reflect," Coombs warns.

"With global economies looking vulnerable, this is no time to take unnecessary risks with capital for a short-term win. Investors could be facing serious potential losses if they don't take a more measured approach."

A measured approach means taking a longer-term view on the region. China's growth and re-emergence as a major world economic force certainly back up its global importance. While China contributed only 3.7 per cent to the global economy in 2000, it is forecast by the International Monetary Fund to account for 11.1 per cent of world output in 2014.

It overtook Germany to become the world's third largest economy behind the US and Japan in early 2009, and this August overtook Japan. The London Business School predicts it will pass the US by 2020 and Goldman Sachs forecasts it will be the world's largest economy by 2027.

"There is a strong case for investment in China over the long term," says Darius McDermott, managing director of Chelsea Financial Services. "The shift from West to East is undeniable, and I believe foreign investment and a growing middle class will continue to power growth.

"Also, it is clear that the majority of UK investors are underweight in China and other emerging markets. While emerging markets have a global market capitalisation of 16 per cent, Investment Management Association data revealed that UK investors allocate just 1.9 per cent of their total portfolio to these markets. A medium-risk investor should have at least 5 per cent."

Jason Pidcock, manager of the Newton Asian Income fund, agrees that China has long-term potential. "Globalisation is helping China to create a large affluent class with significant buying power," he says. "The world, having already reaped the rewards of China's productive power over the past decade, will now begin to feel the force of its consumptive power."

But a more pressing issue for China is its currency. The country is trying to turn the yuan into an international currency to reduce its reliance on the US dollar, euro and yen and to encourage other countries to use it as a reserve currency.

But the move could have huge implications for investing in Chinese equities, says Stephen Ma, the manager of Fidelity's China Opportunities fund. "Chinese companies deriving their earnings from Chinese domestic consumption and those industries reporting earnings in foreign currencies are likely to be beneficiaries," he says. "Chinese end-consumers will also be beneficiaries, as will those companies importing goods from outside China."

He pinpoints financial companies, casinos and cars as sectors set to benefit from the yuan gaining in status. But as David Kuo points out below, it may not just be Chinese companies that will benefit. You could gain from China's potential growth by investing in global funds or shares in UK firms.