Getting in on China's stock boom

By Bill Powell, Fortune senior writer

(Money Magazine) -- The group gathers every weekday: At least four ladies, and sometimes as many as eight, gather at the cavernous, badly lit brokerage office on Shanghai's Xiangyang Lu in what was known, when China was colonized by European powers in the 19th century, as the French Concession.

Retirees all, they come with tea, nuts, and candies to snack on. They plop down at a table in the main hall and watch the electronic stock ticker track the day's activity. They trade gossip, peruse a few business papers, and discuss investment ideas.

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These stock-crazed seniors capture the mania -- obsession, some would say -- that is the investment game in China.

Even though the ladies are all over 60 and are playing with small sums of money, they are really traders, not investors. They buy and sell frequently, often on the flimsiest of rumors. "Everyone knows," whispered Hong Feng, a former schoolteacher, conspiratorially to a friend in early November, "that the government wanted the stock market to go up this year. But now they think it might be getting too hot. It might be time to sell."

Well, everyone may or may not know what Beijing's central planners want. But when it comes to the global economy, this much is true: 2009 was China's year. In the face of a brutal recession in the developed world, China powered ahead, posting unexpectedly brisk economic growth on the back of government stimulus and a huge increase in bank lending.

And China's stock markets in Shanghai and Shenzhen responded. By late November the so-called A shares -- which account for the vast majority of Chinese stocks traded -- in each city had shot up 70% and 105%, respectively. The MSCI Broad China index, which tracks a composite of Chinese companies that foreigners can invest in on overseas exchanges, had risen 66% by the end of November. And investor enthusiasm for the China growth story seems likely to continue in the year ahead, given the nation's equally strong economic outlook for 2010.

But don't let visions of dazzling returns blind you to the risks of investing in China, where stocks often appear to trade less on rational factors -- like how much a company will earn over time -- and more on the rumors and gossip that the ladies of Hong Feng's group love to parse. Before deciding whether you too should invest there, make sure you understand the dynamics at work.

Prepare for a rough ride

China's domestic equities market is still immature -- and highly volatile. Most stocks listed in Shanghai and Shenzhen are open only to Chinese investors (though foreigners can invest directly in a more limited number of companies through the thinly traded B share class). Meanwhile the Chinese -- with their famously high savings rates -- have limited opportunities to put their money to work in foreign stocks.

So the homegrown market is effectively a closed shop. Banks pay almost no interest on deposits, leaving equities and real estate as pretty much the two main options for individual investors. And institutional fund management is still very small.

So rather than being guided by large shareholders that crave stability, the Chinese stock markets are dominated by skittish amateurs.

Put it all together, says Francis Cheung, chief strategist at CLSA Securities, an Asia-focused research firm, and you have an environment where "people do tend to get whiplashed. It's not yet a buy-and-hold market."

Indeed, talk about violent reversals: At their peak in 2007, Chinese stocks in Shanghai and Shenzhen traded at a stratospheric 50 times earnings before falling more than 60% in 2008.

That volatility inevitably translates to the Chinese equities that are readily available to foreigners through direct listings in New York or Hong Kong or the myriad China mutual funds and ETFs. But the good news, says Cheung, is that Chinese stocks sold abroad "tend to trade more efficiently than the market in China," partly because they are typically higher-quality companies with transparent accounting. It's also because those markets are highly competitive. When Shanghai and Shenzhen traded at 50 times earnings, the MSCI Broad China index was at 20.

Understand the big picture

What's the smart way to approach such a high-risk, high-reward market? Start with the macro outlook. Chinese authorities threw the kitchen sink at the economy in 2009 to keep it afloat and "are determined to do so again in 2010 and beyond if necessary," says Henry Chan, who manages the Greater China Fund (GCH) for Barings Asset Management.

There's a lot of chatter about whether China is reinflating two bubbles (real estate and equities). But bear in mind this critical point: If in the U.S. the tried-and-true axiom is "Don't fight the Fed," in China it is "Don't fight the State Council" (the highest domestic policymaking body, to which the People's Bank of China reports).

Loan growth from state-owned banks increased 30% in 2009, and the government has indicated that it will slow only gradually in 2010, to a targeted rate of about 20% growth. At the same time the government's stimulus spending will continue in 2010, further boosting construction companies, which have been riding the boom this year.

Exports are also beginning to pick up as the global economy gets off the deck. And there is no visible threat of inflation. The bottom line, says Chan, is that the growth should continue to flow through to corporate earnings in 2010 -- and, presumably, to stock prices as well.

Be a really picky buyer

That doesn't mean you should invest indiscriminately. Gauged against expectations of future earnings growth, Chinese equities are "not expensive, but they're not supercheap either," says CLSA's Cheung. Nearly all analysts agree on the major themes that ought to work in 2010. The biggest? More infrastructure, which means material stocks should continue to ride high.

Consider General Steel Holdings (GSI), which trades on the New York Stock Exchange. The company -- which, as CEO Henry Yu says, is in the business of helping "consolidate via acquisition and joint ventures" the Chinese steel industry -- is benefiting from the huge infrastructure build-out in and around Xi'an in central China. Recent acquisitions should expand its reach into northeastern China.

Analysts expect GSI's earnings to soar 190% in 2010, and the stock has more than doubled as a result, moving from $1.84 last spring to just over $4 recently. But if it can deliver that earnings increase next year, it should have room to move higher.

The other major theme: growth in spending by Chinese consumers. Sales of cars, appliances, consumer electronics, and apparel all either boomed in 2009 or showed signs of recovering as the economy gained steam.

The challenge again is to be selective, because a lot of these stocks have run up in 2009. But the overall trend still looks promising: Urban Chinese have money, they aren't in debt like their American brethren, and they are buying a lot of things they didn't used to purchase -- such as life insurance.

That's why Chan of the Greater China Fund is bullish on Ping An (PNGAY), China's second largest insurer, which trades over the counter in the U.S. The stock has more than doubled recently. But with its rapid expansion in banking and asset management as well as insurance, Ping An still has solid momentum going into 2010.

In fact, if there's one word to describe China these days, momentum is it. The best way to capture that generally is to buy shares in a mutual fund or ETF that focuses on the Chinese market (for specific picks of these and other international funds, see the table below). In 2010 the message from China is straightforward: If you can stand the rough current, go with the flow.  To top of page

Easy ways to go global
Interested in other investment opportunities abroad? The low-cost funds and ETFs below will allow you to take advantage of international trends.
Fund   One-year return* Expense ratio*
China funds
Matthews China (MCHFX) Invests in Hong Kong and mainland shares of all sizes 78.30 1.23%
PowerShares Golden Dragon Halter USX China (PGJ) Sticks with Chinese stocks listed on U.S. exchanges 50.52 0.60%
iShares FTSE/Xinhua China 25 (FXI) Owns the 25 biggest equities listed on the Hong Kong exchange 68.37 0.74%
Emerging markets
Vanguard Emerging Markets (VEIEX) Tracks the MSCI Emerging Markets Index 4.03 0.37%
T. Rowe Price Emerging Markets (PRMSX) Seeks industry-leading companies in the developing world 4.33 1.20%
American Funds New World (NEWFX) Buys developed-world stocks with emerging-markets exposure 71.6 0.95
Developed markets
Vanguard International Explorer (VINEX) Buys small- and mid-size stocks in the developed world 52.21 1.18%
T. Rowe Price International Discovery (PRIDX) Favors small foreign companies with fast-growing earnings -12.43 1.21%
Artisan International Small-Cap (ARTJX) Looks for fast-growing small stocks all over the world -7.99 1.52%
Broadly diversified funds
Dodge & Cox International (DODFX) Seeks undervalued stocks in developed and emerging markets -11.73 0.65%
Vanguard FTSE All-World Ex-U.S. (VEU) Invests in large- and mid-cap stocks outside the U.S. 37.58% 0.25%
Fidelity Spartan International (FSII x) Tracks the MSCI EAFE index of foreign stocks -10.73 0.1
Sources: Morningstar, Bloomberg
*As of January 21, 2010
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