For decades now, investors and companies have been trying to position for an emergent China. Foreign direct investment has grown to $289 trillion in 2014 from just $38 trillion in 2000.
The Shanghai Composite index surged an annualized 21% a year over the seven years to mid-2007 as investors poured into the trade.
However, the China trade hasn’t paid as well since the end of the Great Recession.[ad#Google Adsense 336×280-IA]Economic growth has slowed to just under 7% and the Shanghai index has returned just 1.6% annually over the six years to 2016.
To make matters worse, the Chinese Yuan has depreciated 6.8% against the U.S. dollar since 2014, meaning lower returns when translated to the greenback.
The Chinese government has yet to be successful in its move to transition from manufacturing to a consumer-driven economy and weak growth abroad means export growth will remain sluggish.
Against this outlook, there is still one China play that’s working. Best yet, this group of stocks should do well whether that economy picks back up or not.
Pollution In China Is At Dangerous Levels
Beijing issued its highest smog alert of the year in early December, raising the warning level and reporting PM2.5 levels of 976 micrograms in parts of the city. The reading was the highest since January 2013 when it reached 886 micrograms and forced the suspension of operations at 2,100 major companies along with a stop in all construction activity in the city.
PM2.5 measures a tiny particulate matter that is harmful to human health. The World Health Organization considers a safe level at 25 micrograms per cubic meter while China’s own national standard for safety is 75 micrograms. Tracked hourly by the U.S. Department of State, China’s PM2.5 reading has been above 75 more than a third of the year to November and has been above 25 for 70% of the year.
Every month over the last year has seen levels at ‘Unhealthy’ or worse — with four months reaching levels of pollution beyond the scale’s measure.
The dangerously high levels of pollution in China could make it difficult for the government to engineer its growth target for the economy. Even as the government tries to guide the economy away from manufacturing, it still accounts for nearly 43% of GDP. Any restrictions on manufacturing activity to curb pollution or simply lost days of work as employees stay inside could further drag on the economy.
The official Purchasing Managers’ Index (PMI) showed that manufacturing activity declined for the third-straight month in October while the services sector hit a seven-year low. The IMF is already forecasting Chinese growth of just 6.3% in 2016, two percent lower than that recorded in 2014.
The Companies That Will Help Clean Up China
China’s State Council released a national plan in 2013 to reduce particulate matter by 15% to 25% through 2017 in key manufacturing regions, calling for public spending of $275 billion to combat air pollution.
Of course, China is not alone in its need to improve air quality. The global market for air pollution control equipment reached $61 billion in 2014. BCC Research expects the market to grow to $78.4 billion by 2019 with the strongest growth coming from Asian markets.
Donaldson Company (NYSE: DCI) makes a diversified line of engine and industrial filtration products with a presence in China and 33% of 2015 operating income from the Asia-Pacific region. Earnings have been hit on weakening foreign currencies but the company is still free cash flow positive and aggressively buying back shares ahead of a rebound.
Donaldson’s acquisition strategy has helped it gain market share within its two reporting segments. Engine and exhaust filtration products make up 63% of sales with approximately 12% of the $10 billion global addressable market. The industrial filtration segment (37% of sales) holds 15% of its $6 billion global addressable market. Shares trade for 19.0 times trailing earnings with expectations for a 14% increase in earnings to $1.74 per share through 2017.
CLARCOR Inc (NYSE: CLC) claims to be the most diversified filtration company in the world, serving more markets than any other and operating in 20 countries. Air filtration accounts for 50% of the product portfolio with two manufacturing plants and a distribution office in China. A fifth of sales are tied to the oil & gas market but just 1% is to the upstream exploration segment.
The company booked $146 million in sales across Asia in 2014 (9.7% of total sales), an increase of 42% from 2013 and its second fastest-growing segment after Europe. Shares trade for 17.8 times trailing earnings, below the five-year average multiple of 22.1 times earnings.
Risks to Consider: Continuing strength in the U.S. dollar could weigh on earnings of U.S. companies’ international operations, creating short-term pain from the long-term gain of international expansion.
Action to Take: Position in the only China play left through companies selling air filtration and other pollution controls in the country.
— Joseph Hogue
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Source: Street Authority