The new China rules for investing
When the Chinese economy recovers, domestic producers, not exporters, will benefit from the rebound.
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NEW YORK (Fortune) -- It feels nothing like 2007 these days, except in one respect: Chinese stocks are outperforming again. The MSCI China Index, which tracks stocks traded in Hong Kong, has climbed 67% since late October (the S&P 500 has risen 2% in that time).
Analysts are debating whether or not the rally - which has slowed in recent weeks - will persist. Morgan Stanley strategist Jerry Lou warned investors last week that Chinese stocks were overvalued, writing in a note, "Although we now envision a marginally less severe earnings recession in 2009...the market has rallied ahead of fundamentals." Meanwhile, Goldman Sach's Hong Kong strategist, Timothy Moe, raised his forecasts for two Chinese stock indexes on Monday.
"People are worried that these stocks have run up too far," says Hong Hao, an analyst at Brean, Murray, Carret & Co. "But we're still talking about extremely low valuation multiples." The price to earnings ratio of the MSCI China index is currently 12 - three points higher than it was last fall, but twenty points lower than it was in late 2007.
Like U.S. companies, Chinese businesses are reporting underwhelming (although less dismal) earnings. Telecom China Mobile's 5% profit growth last quarter fell below analyst estimates, and state-owned carrier Air China's earnings declined 6%. But while the U.S. market has received little support from its sagging economy, China's economic data has perked up.
"Just about every indicator in China suggests that things have been looking up for months," says Larry Kantor, the head of research at Barclays Capital. "If I had to pinpoint a bottom, I'd say it happened in November or December."
Last fall, the Chinese market was stuck in a rut - stocks sank 60% from August through October, and the country' once-unstoppable gross domestic product growth began to peter out. When American investors' emerging market funds plummeted, they learned that China's export-driven economy was far from decoupled from the U.S.
Then, a couple of things happened, says Kantor. Chinese production cuts exceeded the drop in demand, and the government issued a forceful response, easing credit and boosting public investment. According to Chinese officials, retail spending jumped 15% last quarter, and construction output rose 21%. China's GDP is still relatively stagnant, but last quarter's 6.1% growth was downright cheerful amid a global recession.
While the combination of cheap stock valuations and a resurgent Chinese economy is enticing, investors should take note: The landscape is vastly different from what it was during the emerging markets run-up of 2003-07, when Chinese companies grew fat off of excessive U.S. consumption.
NYU professor Nouriel Roubini recently warned of China's vast trade surplus in a report, urging readers not to "underestimate how much China still relies on exports and trade with the rest of the world for growth."
Richard Gao, whose Matthews China Fund has a category-leading 10.2% three-year return, has increased his focus on companies that sell to Chinese consumers, not Americans. "In the past, global trade was the growth driver; going forward, China will have to rely more on domestic consumption," he says.
Gao likes fields such as consumer staples, whose companies sell goods that consumers buy all the time, like food and consumer discretionary, whose products require a little more consideration, i.e., clothing. Stocks in the latter category are trading at deeper discounts.
He also likes Internet services. One of Gao's favorite Chinese stocks is Netease.com (NTES), which investors can buy on the Nasdaq (many Chinese companies are traded only in Asia and have to be bought via funds and ETFs in the U.S.).
Netease owns a large Web portal that pulls revenue from advertising and online gaming - a surprisingly large cash cow. "That's a trend that's Asia-specific," says Gao. "In countries like Korea and China, online gaming is very popular, and it's still developing rapidly." The stock has a price to earnings ratio of 17 - Baidu (BIDU), a better-known Chinese search company, is trading at 50 times earnings. Netease's 0.15 debt to equity ratio is also about half of that at Baidu.
Hao of Brean, Murray, Carret & Co recommends American Oriental Bioengineering (AOB), which manufactures traditional Chinese herbal medicine, and Chinese Medical Technologies (CMED), a maker of diagnostic devices. Both of those stocks also trade in the U.S.
"The government is pushing for healthcare reform, which will be especially beneficial to companies like these that focus on the lower-end market," he says. Both trade at single digit P/E ratios and had greater than 60% revenue growth last year.
Because there are so many values, says Hao, certain sectors aren't worth their premiums. "Don't touch utilities!" he warns. "They were bid up when investors were risk-averse, and some are trading in multiples of 30 to 40, which is absolutely ridiculous."
Another sector where analysts see a potential downside is financial services. As part of its stimulus package, the Chinese government drastically eased lending restrictions, prompting the country's banks to lend a record $670 billion so far this year. Now, some money managers are concerned that the money is being used for stock speculation, not public investment.
"When governments tell banks to lend, and to do it for non-economic reasons, problems arise," says Kirk Henry, the manager of Dreyfus' Emerging Market Fund. "Even though non-performing loans in the Chinese banking sector have held up so far, they're going to continue to deteriorate over time."
Hao agrees that Chinese banks may not be setting aside sufficient provisions for loan losses. But he thinks that financial services firms are safe for now. "There's concern about bad loans, but that's a few years down the track," he says.
That prognosis may sound all too familiar to U.S. investors. So if you want to go the ETF route, but are still a little nervous about financials, avoid iShares' FTSE/Xinhua China 25 Index Fund (FXI), the top three-year performer, in favor of PowerShares' Golden Dragon USX China Portfolio (PGJ). The iShares ETF is 46% invested in financials, while the PowerShares fund is more diversified - a safer bet for a still-unpredictable market. 
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