'Don't Fight the Party' When Investing in China

China may be increasingly capitalist in inclination, and at ground level. But no one should forget that it’s still a communist, command-driven economy.

Great Wall of China
CNBC.com photo composite
Great Wall of China

If “Don’t fight the Fed” is the mantra in the United States, “Don’t fight the Party” is a wise motto for investors in the Middle Kingdom.

China watchers say they prefer “policy-aligned areas” in the coming year.

Here are five top sectors to consider for the year ahead, according to Pu Yonghao, the chief investment strategist for the Asia Pacific region and head of wealth management research for the investment bank UBS.

This year marks the start of China’s 12th five-year plan, running through 2015. The central government has declared that boosting consumption is its primary push, with China looking to create a more balanced economy.

China’s growth is likely to dip slightly to somewhere in the 9-10 percent range in 2011, from 10.3 percent last year. But China will still be Asia’s driving force, ahead of India’s anticipated 8 percent growth.

While growth will still be strong for China, Pu notes, inflation, higher wages, currency gains and abundant liquidity likely mean the government is going to keep reining in credit. Price controls may also be introduced to curb inflation.

“Before inflation stabilizes, the stock market may struggle a bit, because tightening polices will continue coming up,” Pu said. “The first half of this year, and certainly the first quarter, is going to continue to be bumpy.”

1. Machinery Equipment

This sector benefits greatly from China’s push to upgrade its industrial base and move toward greater automation. The country aims to move up the value-added ladder and away from its dependence on cheap labor, so that its industry can compete better globally.

Chinese machinery makers also benefit from any pickup in global demand. Many companies “have not made any corporate expenditures since the dot.com bubble burst — it’s been a long time,” Pu said. “If they feel the global outlook has improved, they are certainly going to be willing to spend more money on upgrading equipment.”

2. Information Technology

China is spending heavily to upgrade its IT service, with a need for expanded coverage, improved computing systems, and better inventory management.

Woman talking on a phone working on a laptop.
Geri Lavrov | Photographer's Choice | Getty Images
Woman talking on a phone working on a laptop.

This sector isn’t just dependent on corporate and industrial demand, but wins as Chinese consumers go online, buy new gadgets such as smart phones and go digital for work and pleasure.

“The IT sector is going to benefit not only form corporate spending but from consumers as well,” Pu said.

3. Mining

China’s rapid urbanization and heavy infrastructure spending place huge demand on raw materials. Mining companies also benefit from higher commodity prices, although companies involved in smelting and other processing functions may suffer as their cost of goods increases.

The economic recovery outside China also translates directly into higher earnings for Chinese mining companies. If inflation spreads to the United States and Europe, that would drive commodity prices significantly higher.

One concern, though, is that some commodities have already had a very strong run, with gold up 20 percent last year. “Precious metals and some industrial metals like cooper, have had a really good run because of a real shortage of supply,” Pu said. “But the supply of certain commodities is going to be very tight.”

4. Energy

Much like the mining sector, China’s energy companies benefit from higher commodity prices. Oil only rose around 10 percent last year and should have much further to run if the global recovery picks up. “When U.S. or European demand increases, it is going to have a huge impact,” Pu said.

China is on a long-term drive toward cleaner energy sources such as natural gas. The policy push should propel gains in companies that are developing technology in solar and wind power — although many of those companies have already seen their stocks rise in anticipation.

That might restrict stock-price gains in the high-tech end of the sector. “New energy has priced in big policy support,” Pu said.

5. Consumer Discretionary Goods

Luxury goods and discretionary items benefit from the rising incomes in China and the push to increase consumer spending. They also gain from a higher-price environment, since they are more inflation-resistant and even sometimes seen as hedges.

“Like precious metals, precious jewelry definitely benefits because it is a kind of inflation hedge,” Pu said.

It is important to consider how much exposure the company has to China as a portion of its overall business, however. Volkswagen, with major operations in China, would be a good example of a company that will certainly benefit from increased spending in China since it has extensive operations here.

Although consumer staples also benefit from Beijing’s push to increase incomes and consumption, the sector is not attractive in inflationary times.

“They have a headwind because raw material prices are rising, and they are not able to pass on all the inflation,” Pu said.