(FORTUNE Magazine) – NO COUNTRY today is more synonymous with growth, capital gains, and vast opportunities to make money than China. Small investors are crowding into mutual funds that promise to grab some of China's double-digit expansion. Pension funds are pulling cash out of tired LBO funds, where the payoff has dwindled, and handing it to Mandarin money managers who talk of 40% or 50% prospective returns. U.S. companies are directly investing an estimated $3.5 billion a year in factories and offices in China. Talk about a turnaround. Just a few years ago China's investment potential was nil. There were no mainland stocks to speak of, the bottom was falling out of Hong Kong shares in the wake of the Tiananmen Square massacre, and U.S. corporate investment was shriveling. China's politics haven't changed much since then, but investor attitudes have. Today there are more than 50 dedicated China funds managing some $3 billion for institutional and individual investors in the West. You can invest in most of the funds either directly or through a U.S. broker. The stocks of Chinese state enterprises that have gone public can be bought through a broker too, though you may have to pay an extra fee if they are listed only on a Chinese exchange and not in New York or Hong Kong. The wave hasn't crested yet. Within the past few months several big Asia infrastructure funds have been launched in New York and elsewhere, aimed at financing roads, bridges, and power plants in China as well as in other developing countries. Says Philip Tose, chairman of Peregrine Investments Holdings in Hong Kong, which will manage one of these funds: ''Chinese consume 711 kilowatts of power per capita, vs. 11,333 per capita in the U.S. The potential is enormous.'' So it is. And nothing conveys that potential more vividly than a firsthand look at the mainland's amazing transformation. In something of a ritualistic dance, American pension fund managers arrive in Beijing in groups of 50 or more for banquets with party bureaucrats, then fly down the coast for factory tours around Shanghai, move through the thriving southern province of Guangdong -- where GDP rose 23% last year -- and end up meeting with analysts in Hong Kong. Separate trips have been organized by Morgan Stanley, pension adviser Frank Russell, and Institutional Investor magazine, among others. The camera-toting money managers return to the U.S. eager to pump their portfolios full of China's prosperity. The question is, Are they right, or just dangerously naive? Maybe they're both. Like the boom in junk bonds in the 1980s or in the Nifty Fifty stocks of the early 1970s, investment in China has merit -- lots of it. But there are risks too, and they are getting bigger than most investors realize. Says Morgan Stanley's Barton Biggs, who has been investing internationally for more than a decade: ''I am disconcerted by the view that no one thinks he can lose money there.'' But then there's the growth. China is the world's largest consumer market, with 1.2 billion people whose incomes are rising rapidly. A McKinsey study concludes that China has 60 million people who have per capita incomes of $1,000 a year or more, the level at which consumerism begins to blossom. These new consumers will need power plants, designer clothiers, McDonald's, you name it. And they represent just a small fraction of the population. The potential for a huge consumer market is staggering. So why are longtime China watchers starting to worry? One reason is the sheer speed at which the country is changing from a plodding state-planned economy to one driven more by market forces. While the direction is right -- and the scope is impressive -- the transition is not without troubles. One point of concern: China's entrepreneurial provinces along the coast are racing ahead at GDP growth rates of 20% or more, fueled in large part by foreign capital. Inflation is high, but rising wages ease the bite. Inland growth is much slower, and while prices are rising just as fast, wages are not. The government has tried without much success to quell inflation, mainly through price controls on some essential commodities. Demonstrations and other signs of social unrest appear to be growing. A more immediate worry for investors is that if inflation is not checked, China's currency, the yuan, could be devalued. Investors only have to think back a few years to a period when China's government was devaluing the currency every few months. Growth is nice, but so is capital preservation. POLITICAL RISKS seem to be rising too. Can the market keep liberalizing without creating a strong desire among citizens for more freedom in other areas of life, leading to another bloody confrontation with the old-line Communist leaders? And what happens to China's power structure after Deng Xiaoping dies? Such concerns do not negate the long-term case for China, but they do make it less of a sure bet. Investors need patience, smarts, and a strong stomach for volatility. Many institutional investors are no longer wrestling with whether to go east, but how. Some are buying China's listed securities, which are multiplying fast, while others are taking the leap into direct investing, where liquidity is traded for the expectation of eventual fat payoffs. Smaller investors are generally limited to China's listed stocks or to funds that specialize in them. While direct investment funds are struggling, stocks and stock funds commonly produced returns of 50% or more in the past year. Direct investment starts with one big advantage over listed securities -- the price of entry is lower. Western investors can typically buy into an existing Chinese enterprise on the private market for as little as five times earnings, vs. ten to 20 times for publicly traded companies. But for many of the funds that were launched to do private-market investment, that advantage is purely hypothetical. Says William Overholt, an economist at Bankers Trust in Hong Kong: ''Many of these funds simply lack the ability and contacts to turn up good deals.'' As a result, even direct investment funds often end up parking cash in the same place individual investors do -- in the listed securities markets. One direct investment group that has had considerable success is Chinavest, a 14-year-old investment firm that started putting U.S. institutional money into China in 1985. The firm is headed by Robert Theleen, who was an Army intelligence officer in Vietnam during the war and stayed in the region. One of Chinavest's recent projects: a glittering new $3.8 million entertainment center in Guangzhou, which opened in late January. With pension money from IBM, among others, Chinavest has undertaken 18 projects in China over the past nine years. It never goes in alone. ''You need partners and connections in China,'' says Christopher Gray, a Chinavest vice president. ''We wanted the entertainment center to appeal to parents, so we joined with the National Women's Institute, an association of women throughout China.'' Through such team play, Chinavest has been able to generate modest double-digit annual returns over the past nine years. With China's risks rising, so must the expected returns. Morgan Stanley, which has been investing there for ten years, calculates the country's risk premium at 19%, meaning an investment in China must offer a prospective return that beats U.S. Treasury bills by at least 19 percentage points. That assumes that the Chinese investment is liquid, as a stock is. An illiquid investment has to do even better, by far. Direct investment fund managers say the potential returns they are offering investors today must be 30% or more. That will be hard to make. Even when the performance bar was lower, most direct investors found the going too rough. A number have pulled out. Jardine Fleming, one of the original direct investors, has largely quit. Among its early missteps: opening a new restaurant for tourists near Tiananmen Square in 1989, just a week before the shooting began. Baring Asset Management also dropped out, opting like Jardine to concentrate on listed securities. Other funds have come in to replace them, but many have yet to find deals that will generate the kinds of returns their clients expect. Observes Victor Fung, chairman of Prudential's Asian subsidiary in Hong Kong: ''There's just too much money chasing too few deals.'' Fung, who manages a $500 million portfolio for Prudential Insurance, also worries that direct investment is not yet suitable for pension funds, which have a fiduciary responsibility. ''There are no clear laws in China, and you can't say for sure how you're going to get your money back. Normally in direct investments you can get it back at the initial public offering. But even if you are a big investor in a state enterprise you have no say in when or whether it goes public.'' Fung's family has invested in China, but when he wants China exposure for the pension money he manages, Fung sticks to public companies throughout Asia that have projects in China. That way he retains liquidity -- he can sell his stock when he wants out. As more Chinese enterprises go public, the opportunities to cash out of a direct investment get better. Even so, the daunting bureaucracy can stifle deals before they get started. Investors seeking a direct investment often need hundreds of separate approvals from regional and local officials. Shanghai has tried to ease this problem by assigning Alex Ye, one of its senior officials, to the Hong Kong offices of Arthur Andersen. Ye has the authority to provide multiple approvals, or chops, that allow investors to bypass many smaller commissions and ministries. ''I run a one-chop shop!'' he proudly exclaims. Even so, the obstacles to entry remain high. GIVEN the difficulties faced by direct investors, it's no surprise that much of the action lately has been in China's growing list of stocks. The big state-owned industrial enterprises began making initial public offerings when the Shanghai Stock Exchange opened in 1990. A second exchange, in Shenzhen, just outside of Hong Kong, began listing companies the following year. Until 1992, only Chinese nationals could buy these shares. Then a separate class known as B shares was created for foreigners. In 1993, Beijing began to let some of its larger enterprises sell stock on foreign markets, beginning with the Hong Kong Stock Exchange. Since then six have gone public in Hong Kong, with a combined market value of roughly $1.9 billion. Three more mainland companies should list in Hong Kong early in 1994, and another batch of 22 is reportedly being readied. Four Chinese stocks have also listed on the New York Stock Exchange. The Big Board not only has higher P/E multiples than does Hong Kong -- 37.9 vs. 20.6 at the end of 1993 -- but it also has deeper pockets. Big IPOs done by Chinese companies in Hong Kong have soaked up so much of the colony's available cash that money market rates shot up by as much as two points. The stocks are generally performing well -- many returned more than 50% last year -- but there are plenty of risks too. The government maintains control of many enterprises, and shareholders do not enjoy the readily enforceable rights of ownership that exist in capitalist markets. Only last December did China adopt an official ''company law'' recognizing the ownership rights of shareholders, and this will not take effect until next July. Says Cheuk Yan Leung, an attorney at Baker & McKenzie in Hong Kong who has worked on a number of China's stock offerings: ''When it comes to very basic laws protecting investors, China has a lot of catching up to do.'' Such shortcomings may not become apparent until trouble strikes. Assume, for example, that a publicly traded Chinese enterprise -- one that you own stock in -- goes under. Shareholders theoretically have a claim on the assets, but that claim has never been tested. Some investors fear that the state would grab all the assets. Welcome to the quasi-capitalist market. ASIDE from legal considerations, just how good are these companies? The answer, for many, is not very. High-level Beijing bureaucrats privately concede that roughly one-third of China's state enterprises are hopelessly uncompetitive and should be shut down. They are kept alive only to avoid massive unemployment. Of the remaining two-thirds, half must change dramatically in order to survive without state subsidies. Only the rest can enter the marketplace in anything resembling their present condition. The better companies have gone public first, but among the thousands more that could be listed over the next few years there presumably will be many that should be closed. To make enterprises more competitive -- and more attractive to investors -- China is slowly freeing them from the enormous social burdens they have borne. From steel mills to petrochemical plants, they have long been expected to give workers a lifetime of social services, including education, health care, and housing. Western investors hardly want to take on those obligations. But removing the vast social superstructure will be a monumental task, since China has no other safety net for its masses. Shanghai Steel Tube, a manufacturer of stainless-steel tubes that is slated < to issue B shares on the Shanghai exchange in March, is a prime example. In preparation, it has been making a number of changes, including reducing the head count. Of the 5,000 employees on the payroll, 1,000 are retirees enjoying what Chinese call the ''iron rice bowl,'' the wage and benefit dole that never stops. President Gong Hong Lin says the company has ''severed most of those obligations.'' Says Peter Churchouse, research director of Morgan Stanley Asia: ''These companies come to market with lots of socialist baggage.'' The company has created a board of directors to replace supervision from a government ministry. Gong says she now makes production decisions based on market demand but will confer with her board for more important decisions, such as changes in product lines. Says she: ''Not just the operations of this company must change; the management systems must change as well.'' The motives are good, but big questions remain about the profit potential of transformed state companies. Though managers and their boards will have more say, the government will still be the majority owner of many of these companies. Argues Gao Shangquan, a former vice minister of the State Commission for Restructuring Economic Systems: ''There's nothing wrong with that. Some 20% of the FORTUNE Global 500 is state-owned.'' (Actually, state companies constitute only 5% of our list.) Shareholders must also contend with inadequate financial information, though the Chinese are trying to improve the situation. When a company gets ready to list, staffers of major U.S. accounting firms move into its offices to convert communist-era accounting to a Western, profit-oriented standard. The job took Arthur Andersen 6,000 hours at Tsingtao Brewery. The Ministry of Finance recently issued new accounting standards intended to bring Chinese accounting closer to that of the West. That may be wishful thinking. Says Meocre Li, managing partner of Arthur Andersen in Hong Kong: ''It's easy to put out new standards, but the interpretation of them at the company level may not be the same as what the MoF intended. Also, there is no venue for companies to clarify whatever problem they have. Even the local accounting firms have problems understanding the new standards.'' Chinese companies traded in Hong Kong and New York are held to tough standards imposed by the exchanges. The Hong Kong-listed companies, for example, must have their past three years' results adapted to international ^ accounting standards and audited, vs. only one year for companies seeking a B- share listing in China. Because of these better reporting rules, many big investors pass up the domestically listed shares entirely and focus only on those listed in Hong Kong. With only six on the Hong Kong Exchange so far, the flood of buyers has pushed prices up dramatically. As a result, analysts say that investors can now find more value in the lower-quality, lower-priced B- share markets. A better strategy may be the stock of an American company that has been successful in China. One example is Motorola. The semiconductor and cellular phone company entered China slowly back in the late 1980s. Despite an enormous potential market -- in China there is only one phone for every 102 people -- Motorola spent the first few years shipping pagers and cellular phones from the U.S., keeping capital outlays to a minimum. In 1993, with sales growing 100% a year, Motorola built a plant in Tianjin, and it is now expanding it. It's also looking for other plant sites and is putting up a training center for Chinese engineers, Motorola University, in Beijing. Sales in China are now the fastest-growing part of Motorola's business. Pager sales went from 100,000 units in 1991 to more than four million last year. Motorola's go-slow, have-patience approach to China may also be the lesson for today's China-bound investors. The poor performance -- at least initially -- of most direct investment in China painfully reveals that a developing economy is as full of pitfalls as it is of promise. Direct investment is a long-term play, and only with distant horizons can investors hope to reach the payoff. Institutional investors who must think short term are stacking the odds against themselves in China. Small investors who look for a quick payoff are doing the same. Stock markets in China and Hong Kong are not cheap. China may well turn out to be the best investment of the decade, but only for investors who give it a decade.

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