great wall of china
click to enlarge

A few weeks ago Burton Malkiel, author of the best seller A Random Walk Down Wall Street , wrote an op-ed in the WSJ titled,  “Why Investors Need China in Their Portfolios”. In the article Burton Malkiel states that investors need to open their eyes (and their wallets) to the Chinese and global economy.

While I do not agree with Malkiel on this subject, I am playing Devil’s advocate in this article, and will follow up with another article today stating why he is wrong.

Malkiel states that the United States is not the only country in the world that has businesses, and in fact, many other countries are growing at a faster pace than the U.S. Rather than limit earnings and returns to the companies that are located in our home country, why not open up to the world for lower risk through diversification, and likely higher returns as well?

One of the simplest concepts in finance is diversification; a process which can be described as the age old, “don’t put all of your eggs in one basket.” That theory has helped countless investors to eliminate unsystematic risk associated with individual companies or industries. However, while many investors cite diversification as one of the most elementary of techniques used in investing, too many seem to overlook the fact that only dealing with one country is almost as dangerous as only dealing with one business or industry. So why continue to roll the dice on a single market? Malkiel cites the “home country bias” as a major reason.

It could be from a fear of other markets. That makes sense as the SEC doesn’t regulate the other major players of Europe and Asia, let alone third world countries. And aside from the accounting and financial regulations being a little bit different themselves (GAAP Vs. IFRS, which could cause large discrepancies in the financial statements of the same company, depending on which method is used), investors also have to worry about other aspects such as revolutions, and political policies interfering with companies operating in their countries. That would actually force investors to pay attention to global issues and politics, as well as learn all new valuation methods; nothing like the good old USA markets at all.

Still, the aforementioned reasons for discomfort don’t justify not getting into foreign markets. Malkiel cites several major figures that must be taken into account before anyone can dismiss investing globally. The fact that the United States accounts for only 20% of the world’s GDP shows that we are a major player, but not the only one. With China being the world’s fastest growing economy, you would expect their market to present great opportunities. But when you realize that they have been the fastest growing market for nearly 30 years, it’s a wonder why some haven’t jumped onto the bandwagon yet! Malkiel also cites that the Chinese economy has grown at a rate greater than 9% after inflation since 1980! Yet Malkiel states that valuations are reasonable in China, with the market PE close to mid-teens, and the PEG ratio very low.

Malkiel states that while growth for a period of time as long as this has been unprecedented, it also has no reason to slow down in the near future. Part of the Chinese machine is that their population continues to grow along with their infrastructure. That being said, they cannot continue to pour their resources into development forever, and their GDP composition will eventually have to change to a more domestic consumer based economy like the US. China cannot continue to export at their current rate, let alone grow their exports, while most of the rest of the world is suffering in this economic downturn. Additionally, China is manipulating their currency , the yuan or RMB, to boost exports, and will eventually have to stop this currency manipulation. Any revaluing of the Yuan will cause a sharp decline in Chinese exports.

Malkiel makes a few more points about consumption, the leveling off and smoothing of China’s growth, and even the political affects that are starting to shape China’s future. The point is that China may have a few issues to look out for, but other than that they should be a major investment in everyone’s portfolio. Malkiel states that he believes the world doesn’t value China for its true ability and wealth, and that all investors would be well served to look into investing in the country.

Disclosure: No positions in any Chinese companies or ETFs that have exposure to China