China Stocks Cheapest ‘I’ve Ever Seen’: Index Pioneer

Chinese stocks are extremely undervalued and U.S. investors should heavily increase their exposure to benefit from the emerging market’s long-term growth, says Burton Malkiel, author of the financial classic “A Random Walk Down Wall Street.”

The economist was referring to a slide showing several valuation metrics—from the price-to-earnings and price-to-book ratio—for the AlphaShares family of China indexes he created.“These are the most attractive multiples I’ve ever seen,” said Malkiel, 79, who pioneered the indexing investment philosophy, at a speech Wednesday for Guggenheim Funds at the New York Stock Exchange.

Malkiel helped forward the efficient market hypothesis—that prices of stocks immediately reflect all public information—with his 1974 classic now in its 10th edition. The professor of economics at Princeton argues that this hypothesis means investors are better off buying and holding a large basket of stocks through indexing, rather than relying on active fund management. He turned his sights to China about eight years ago.

As one would expect, Malkiel made clear that he wasn’t making a market timing call to buy China immediately, but rather saying that investors will be forced to increase their exposure to the world’s most populous nation over time as its economy transitions to more domestically focused and its currency begins to rival the dollar.

Right now, a typical institution holds just a 1.7 percent exposure to China, according to Malkiel, based on an average 10 percent exposure to emerging markets and China’s 17 percent chunk of the emerging markets pie.

Their overall exposure “should be at least 9 percent to better match China’s contribution to global GDP,” said Malkiel. “And that’s conservative. It really should be 12 percent.”

The economist, who is also chief investment officer at indexing firm AlphaShares, said the best way to capitalize on his China investment thesis is through Renminbi bonds or Chinese equities.

China’s stocks exploded higher this week after the government signaled there may be an end to monetary tightening. A European bailout plan on the table also soothed fears of slowing exports.

“These buildings may not be standing in five or 10 years,” said Jim Chanos, president of Kynikos Associates, in September. “You’re talking about an economic system where profits are not maximized for the largest economic actors. You’re talking about a history of horrible lending. You’re talking about a system in which the export-driven model hasn’t been changed by Western demand.”To be sure, not everyone is as enthusiastic as Malkiel. Detractors point to a build out in infrastructure to the center and West of the country that is taking place before a migration in the population. Not to mention rampant corruption and accounting practices.

But Malkiel, who remarked, “Chanos is just talking his book” at the speech, believes China is fostering faster growth by building the infrastructure ahead of the population migration and business growth. Behind his bullish thesis is the belief that domestic consumption will one day account for as much as 50 percent of the country’s GDP.

Sticking to his broad exposure roots, Malkiel has developed several indexes at AlphaShares that hold many more stocks than other Chinese indexes, which tend to be heavily weighted toward a few companies in the energy and finance sector.

Guggenheim, which sponsored his talk, offers exchange-traded funds that track the Malkiel indexes.

They include the Guggenheim China All-Cap [YAO  24.3699    -0.1701  (-0.69%)   ]China Small Cap [HAO  22.42    0.08  (+0.36%)   ] and the China Technology[CQQQ  24.69    -0.289  (-1.16%)   ].

What’s more, the firm has ETFs that give the regular investor direct exposure to Chinese bonds via the Yuan Bond [RMB  24.86  —  UNCH    ] and a direct hit on Malkiel’s currency appreciation thesis through the Chinese Renminbi Trust[FXCH  79.15  —  UNCH    ].

“Some people think the Yuan [CNY=X  6.357    -0.002  (-0.03%)   ] is as much as 20 percent undervalued,” said Jeff Kilburg, a trader with Treasury Curve who attended the speech. “If Malkiel is right and China continues to allow it to appreciate at least 5 percent a year, that will attract more and more investors. And the country’s bond market is in its infancy right now.”

Given the U.S. budget deficit and growing debt load, Malkiel believes that China’s currency could eventual rival the dollar. They desperately want the benefits that the U.S. has with being the world’s reserve currency and being able to print your way out of most problems.

“They dislike that immensely,” said Malkiel. “They call it ‘the exorbitant privilege.’”

By: John Melloy
Executive Producer, Fast Money & Strategy Session

John Melloy is the Executive Producer of Fast Money. Before joining CNBC, he was an editor for Bloomberg News, overseeing the U.S. Stock Market coverage team. Click here to see his full bio.

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