Riding on a Dragon’s Back

In less than three weeks, China will regain control of Hong Kong, including its vibrant financial center. The transfer is raising anxiety levels worldwide, but many investment pros expect continued prosperity for Hong Kong.

Richard Farrell is among the optimists. He manages the Guinness Flight China & Hong Kong stock mutual fund. In its two years in existence, the fund has had the best showing of any Pacific-region stock fund, according to Lipper Analytical Services.

The fund gained 49% in the two years ended March 31 and has surged an additional 17% since then, propelled by a powerful rally in Hong Kong stocks.

Farrell, 54, oversees half a dozen Asian mutual funds, some for U.S. investors, some for non-Americans. All told, they count about $700 million in assets, with Guinness Flight China & Hong Kong holding nearly half.

Farrell oversees a staff of Asia-based analysts from his office in London. Much of his free time is spent in local politics: He’s a district counselor representing a couple of villages south of Oxford, England, for the Liberal Democrat party. He was interviewed by Russ Wiles, a mutual funds columnist for The Times.

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Times: Given the fresh surge in the Hong Kong stock market this year, it’s safe to say that investors overall are bullish about the transfer of Hong Kong to China. Do you feel this optimism is warranted?

Farrell: Very much so. To be realistic, some human rights are going to be eroded in Hong Kong. There will be changes. But there are many reasons why China wants to see the whole process work smoothly. Most important, there’s the question of face. If Hong Kong doesn’t fare as well under the Chinese as it has under the British, there would be a tremendous loss of face for the Chinese.

Besides, the Chinese really don’t have any alternative but to embrace open markets and international investors in order to provide real jobs in their economy, to make up for those in the old state-owned smokestack industries. Also, in the long term China faces a rising food-import bill, for which they need to generate foreign revenues.

Then there’s Taiwan, which they definitely want to bring back into the fold. The only way they realistically could do this--without taking over the ruins of Taiwan--would be to show that one country with two systems really can work.

Times: Some observers have described Taiwan as ultimately a more significant prize than Hong Kong. Do you agree?

Farrell: Yes, in strategic terms. Quite frankly, the Chinese could have had Hong Kong back any time they wanted over the past 40 years. Hong Kong is indefensible.

Taiwan is an entirely different situation. Getting it back requires much more subtlety and thus certainly would be a bigger prize. But economically, I actually think that the combination of Hong Kong and Guangdong province is potentially the jewel of the crown of Asia. This region has a critical mass, in area and population, of a country the size of France.

Times: What do Hong Kong and China each bring to the marriage?

Farrell: Hong Kong brings two important things. First, its entrepreneurs have been acting for some time as the managing agents for manufacturing in southern China. These entrepreneurs largely have been responsible for setting up light electronics manufacturing, selling the products in Europe and overseeing the management process.

Also, Hong Kong has an absolutely thriving financial market. China requires a marketplace to raise the significant amounts of capital that it needs to continue developing its own industry and infrastructure. Hong Kong has the world’s sixth-largest stock market. It’s very well-organized and sophisticated. And following some scandals back in 1987, it has been well-policed.

China offers a slightly more mixed bag. Most significant, [unification] opens up to a greater extent to Hong Kong a market of 1.2 billion people, with all the long-term potential that comes with that. China also provides Hong Kong’s food and water, which is not insignificant.

Times: Which stock market regulations will be used after July?

Farrell: I hope it will be more a case of China moving to Hong Kong’s standards. China’s embryonic market [in the past] rested on an uncertain accounting and legal structure.

The Chinese now are on a steep and rapid learning curve, which they’re going up impressively in terms of laying an accounting and legal foundation. They also are coming to realize that they must manage shareholder relations. It’s not just a question of taking money from shareholders and forgetting about them, as happened in the past.

Times: You mentioned Hong Kong’s entrepreneurs as an important factor. Is there a danger that they will flee after the transfer of Hong Kong to China?

Farrell: Quite the opposite. In the mid-1980s, a lot of Hong Kong entrepreneurs did leave, taking up residence abroad. But most have returned to Hong Kong with Canadian, Australian, U.S. and British passports. They prefer to live in Hong Kong. For example, there was an article in the British press in April pointing to the fact that so many Chinese were returning to Hong Kong that the residential real estate market in Vancouver was suffering.

Times: Your fund invests primarily in Hong Kong shares. Do you also invest directly in mainland Chinese companies?

Farrell: A few. But these investments are a small element for the fund, representing maybe 3% or 4% of assets. The problem is that the liquidity of these Chinese shares is just not sufficient. The fund has more than $300 million. That’s just too big for most of these Chinese plays.

Times: In addition to Hong Kong-based companies, there are the “red-chip” stocks. What do you think of them?

Farrell: The red chips are Hong Kong companies in which a mainland government entity, quasi-government organization or municipality has taken a significant stake as equity investors.

The hope and expectations are that from time to time, these companies will be given a chance to participate in interesting investment opportunities in the province or city [where the Chinese entity has jurisdiction]. This certainly has happened in the past. The problem is that you must buy these red chips on an act of faith that it will continue to happen.

Times: Does your fund own any red chips?

Farrell: Yes. One example is the largest and oldest of the red chips, a company called Citic Pacific. It’s a conglomerate with a range of interests, including a significant stake in Cathay Pacific Airways and China Light & Power, which just recently struck a deal to develop some power projects in northern China. Citic also owns about 28% of a company called Dragon Air, which provides internal air service in China.

Times: How about your mainstream Hong Kong holdings? What are some examples, and why do you like them?

Farrell: HSBC Holdings [parent company of Hong Kong Shanghai Bank] is the largest individual holding. It represents more than 20% of the Hang Seng index [the main Hong Kong stock index] and is one of the core blue chips owned by just about any Asian portfolio. It’s a very successful bank, although in the short term the share price has gotten overcooked, and we’ve been moderate profit takers in some of our other portfolios.

Times: Any non-banking stocks that you like?

Farrell: Yes. One is a company called Li & Fung. It’s a high-quality operation run by a guy named William Fung, who has a Harvard MBA. The company acts as a go-between for manufacturing operations in southern China and retail businesses in the West. It oversees the manufacturing process, arranges shipments and acts as sales agent in the United States. It runs a very successful business.

Times: So amid the current rally in Hong Kong’s market, what’s your near-term outlook?

Farrell: I still think the market can keep going, particularly over the next month or two. However, I do expect a consolidation, probably sometime after July.

Times: How about the long-term potential?

Farrell: I think investors who are interested in the story should be buying now. Over the long term, not only do I see continuing growth, but I believe that compared to other Asian markets, Hong Kong actually deserves a re-rating. A lot of people have too negative a view about China taking over. They worry about diminution of freedom of the press and things like that.

I would point out that Singapore has a government that runs things in an authoritarian, although somewhat paternalistic, fashion. It has a one-party system with no great respect for the freedom of the press. Yet that hasn’t prevented Singapore from being an extremely attractive place in which to invest.

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Guinness Flight China & Hong Kong Fund

Strategy: Seeks capital appreciation by investing in Hong Kong and Chinese stocks, mainly larger ones.

VITAL STATISTICS

Year-to-date return: +8.2%

Year-to-date return, avg. Pacific fund*: +3.9

2-year return, through March 31: +49.1

2-year ret., avg. Pacific fund*: +13.6

2-year ret., avg. general U.S. stock fund: +43.0

Five biggest holdings:

1. HSBC Holdings

2. Hutchison-Whampoa

3. Sun Hung Kai Properties

4. Cheung Kong Holdings

5. Hang Seng Bank

Sales charge: none

Assets: $322 million

Initial investment: $5,000

Phone: (800) 915-6565

Morningstar risk-adjusted performance rating, 1-5: not rated (too new)

*excludes Pacific funds that own Japanese stocks

Sources: Lipper Analytical Services, Morningstar