China Points The Way To Profits As The New Global Manufacturing Leader

By Martin Hutchinson

There’s more bad news for those of you who are worrying about the United States’ global geo-strategic position. According to a recent report, starting next year, Chinese manufacturing output will exceed that of the United States.

In concrete figures, of the world’s $11.8 trillion of manufacturing value added output expected to be produced in 2009, China will account for 17%, while the United States will account for 16%.

For investors, even those based in the United States, the implication is clear: a substantial part of any investor’s portfolio should be in China and any other countries where manufacturing is growing as a percentage of the world total.

China’s manufacturing share has been accelerating rapidly since 2000, when it accounted for only 7% of global value added. Back then, the United States accounted for around 25% of the total. China’s growth spurt in the last year has been caused not by any special acceleration in China’s growth, nor is it the product of a sudden collapse in the U.S. manufacturing economy. The decline in the dollar – and the rise of the Chinese renminbi against the dollar – is what has inflated the value of Chinese manufactured goods.

For the United States, economic theory suggests there is no need to panic. Most services have at least some component of local supply, so they cannot be outsourced easily overseas (the exceptions being such services as computer software or accounting). Hence, it is natural that richer countries will tend to specialize more and more in the service sector, while poorer countries become more devoted to manufacturing products that can be easily shipped around the globe.

Nevertheless, there are a number of moderately disturbing implications to this news. To the extent that Chinese or other poor-country manufacturers acquire additional capabilities by manufacturing products for Western use, they may become more competitive in the international market against Western companies. Research and development, in particular, require a deep understanding of the production process to be successful – an understanding that is difficult to acquire from a distant country.

For investors, the exciting opportunities are likely to arise in China, and in other low-wage manufacturing countries that are opening up to Western markets. There are also opportunities in countries, such as Taiwan, that have the ability to marry their own technological capabilities with low wage manufacturing in China or elsewhere in Asia.

To take advantage of this trend, you might look at the following companies, all of which stand to benefit from the move of global manufacturing to China and other low-wage economies:

• Acer Incorporated can be bought through London depositary receipts (ACER.L), which are liquid and quoted in dollars. Acer became the world’s third largest manufacturer of personal computers after buying Gateway last year. It manufactures in cheap-labor China, but has top quality Taiwanese research and design and good relations with Taiwan Semiconductor Mfg. Co. Ltd. (NYSE:TSM), the world’s largest chip manufacturer. Acer yields 12% on a historic basis, but some of that relates to a special dividend on real estate profits; on the basis of its regular dividend its yield is about 7%. Its forward Price/Earnings ratio is 11.

• Dr. Reddy’s Laboratory Ltd. (NYSE:RDY) is India’s premier manufacturer of generic pharmaceuticals, poised to benefit in the 2008 - 2012 period as many popular drugs lose their patent protection and are opened to international competition. It has moderate debt, about 50% of equity, and is also selling at a multiple of 17 times earnings to March 2009, with a dividend yield of only 0.8%. Again, the relatively high rating reflects the growth potential in Dr. Reddy’s global business, which benefits from low cost and high quality in India.

• Aluminum Corp. of China Ltd. (NYSE:ACH) is an integrated aluminum smelter focused on the Chinese market. It thus benefits from the rapid growth of Chinese manufacturing, as well as rising commodity prices generally. ACH is currently trading at a very reasonable P/E ratio of 7.6 times estimated 2008 earnings, with a dividend yield of 3.3%.

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