One for the China pot

LAST WEEK, I explained that the cheapest way to invest in the growth of China was through the Hong Kong stock market. Not the old Hong Kong of trading and property companies concentrated in Hong Kong itself, but the new Hong Kong of companies with substantial manufacturing facilities and other interests in China.

Before investing in the Hong Kong market, it is necessary to establish some highly selective investment criteria. The first and most important requirement is for companies to have Chinese management. Not because they are more efficient, but because they are far more likely to have good guanxi - the Chinese word for connections: in this case, relationships with the State Council of the PRC, the Ministry of Economic Relations and Trade, the Ministry of Finance, the provincial authorities and the People's Liberation Army. In China, permission is needed to start businesses, sell certain products and conduct operations. Good guanxi ensures that permission will be forthcoming.

The second criterion is the possession of substantial existing facilities in mainland China - proof of past guanxi and the hope of more benefits to come. The third criterion is a business that will benefit from China's strong work ethic, ridiculously cheap labour costs and, hopefully, also from China's potentially massive consumer market.

The fourth criterion is a low price/earnings ratio in relation to the market as a whole and also to the company' s growth rate. We are looking for at least 20 per cent per annum growth and preferably much more. The last requirement is a reasonably strong balance sheet.

No more than 15 to 20 per cent of your portfolio should be invested in your China pot, which should be spread over at least five shares. Innovative International is the first company that comes to mind. The core business is the largest antennae (for car radios and cellular telephones) and car accessories manufacturer in Hong Kong, exporting to more than 30 countries. The company is consolidating its manufacturing facilities in a 760,000 sq ft low-cost production base in Shenzhen in China, which will enable it to undercut all international competition and maintain margins of 25 per cent.

The chairman of Innovative is Stephen Chang, who graduated from the Beijing Institute of Telecommunications. His guanxi is shown by Innovative being the first Hong Kong listed company to set up large scale investments in Tianjin, where he was educated. Present arrangements include a 35 per cent stake in a motorcycle and related components manufacturer in Tianjin, a 50 per cent stake in a battery manufacturer in partnership with the Tianjin Electricity Research Institute, and control of a toy manufacturer in Dong Guan City. The company also has extensive property interests in China and further joint venture companies. The management obviously has a high degree of guanxi; if there is any cause for concern, it is that the company might take on too many projects.

Innovative capitalises at about pounds 100m, with Stephen Chang owning 44 per cent. The Estimate Directory (Pacific Basin) shows a consensus of eight brokers forecasting growth in earnings per share of 26 per cent to give 24 cents for the year ended March 1993. For the following year, the consensus forecast is for growth of 54 per cent to give eps of 37 cents.

At the present price of HKdollars 2.90, the p/e ratio on the 1993/94 forecast is only 7.6. This would be diluted on full conversion of loan stocks and exercise of all warrants outstanding (adjusted for interest savings) to about 8.5. The PEG (the prospective p/e ratio divided by the growth rate) is therefore an astonishingly low 0.16 compared with 1.2 for the average UK growth share. Yes, the decimal point is in the right place - in PEG terms, the price you pay for growth, Innovative is over seven times cheaper than a typical leading UK growth stock. The consensus forecast dividend yield is also an attractive 5 per cent and the company has a strong financial position.

There are about 12 Hong Kong dollars to every British pound, so a price of HKdollars 2.75 is only 23p per share. Settlement for Hong Kong shares is within two days of dealing, so bear this in mind if you ask your broker to buy any shares in Innovative International for you. He may tell you that dealing in Hong Kong shares is all very dificult, but it is well worth persevering for such amazingly cheap PEGs with the tailwind of China's phenomenal growth behind you.

As I said earlier, you should spread your China pot over at least five shares, so factor this into your calculations and keep some money in reserve for future recommendations during the next few weeks.

The author is an active investor who may hold any shares he recommends in this column. Shares can go down as well as up. He has agreed not to deal in a share within six weeks before and after any mention in this column.