China Funds Are Down, but Don't Sell

It's been almost a week since the Beijing Olympics came to a remarkable close and by all accounts the games were a huge success. There were dramatic medal races -- won, in many cases, in world-record fashion -- that played out against a background of stunning architecture and dramatic landscapes glimpsed by many Americans for the first time. Of course, there was some controversy as well. But every sporting event has a little of that.

Beijing, though, can't exactly bask in the glow of its success. In the recent but rapidly receding past, China had the hottest stock market on the planet. Mutual funds investing there averaged returns of more than 50% in 2006 and again in 2007.

But the global economic slowdown has effectively wiped out last year's gains. China funds have lost one-third of their value in 2008, according to Lipper. And it doesn't look like the days of jaw-dropping returns are coming back any time soon. So much for gold-medal performances.

That predicament has many investors worried about what comes next. China and its 1.3 billion citizens are still one of the world's most compelling investing stories. But creeping inflation, slowing GDP and corporate profit growth and the global downturn have wreaked havoc with Chinese stocks. The Dow Jones Shanghai index is down 60% from its highs last October. Indeed, the hot money seems to have already moved on to even riskier so-called frontier markets. Meanwhile, longer-term investors are wondering whether waiting out any rebound is worth the trouble.

That's quite a change for a growth engine that was once the envy of the world. For much of the last decade China's economy had been expanding at a 10% to 11% annual clip, far outpacing most developed countries. It was boosted by economic deregulation, foreign capital seeking out cheap labor and a newly affluent class willing to spend on everything from better food to the latest gadgets. The government also went on a spending binge, building roads, bridges and power plants to support the evolving demands of its citizenry. China also poured more than $40 billion into hosting the Olympics.

But the new prosperity came with problems. As China has grown it has consumed an increasing amount of the world's commodities, contributing to record prices for everything from grains to oil. Costlier commodities, in turn, lifted China's inflation rate to 6.1%, according to investment bank Roth Capital Partners, just as higher energy prices crimped corporate profits. GDP growth is now hovering near 9% -- a healthy number but a slowdown from the pace to which China's grown accustomed. And as the world goes so, too, does China. Its export-dependent growth push is being tested as never before by the developed world's troubles.

The short-term outlook seems drab. Patricia Ribeiro, a portfolio manager of the American Century Emerging Markets fund (TWMIX), predicts the next quarter will once again prove disappointing. She says the Sichuan earthquake and restrictions on manufacturing around Beijing to clear the air for the Olympics will dampen the numbers. But, she adds, "in the fourth quarter we should see a bump up." Ribeiro is also keeping an eye out for the long-rumored government stimulus plan that could take the form of a tax rebate. (It could be approved early next year, she says.) "The government is really focused on helping the lower-income level of the population," says Ribeiro.

Ribeiro's fund is diversified across the world's emerging economies, including large stakes in Latin America, Asia and an 8% allocation to Chinese companies. Ribeiro pays attention to macroeconomic data, but she devotes much of her time to valuation analysis. She prefers companies with accelerating earnings, stable operations and clear advantages. She then tests her best ideas against their peers across the globe. She is bullish on health care in China since the government is building local and rural facilities and the rising middle class can afford care. She also likes China Mobile (CHL), the dominant cellphone player in the country. Ribeiro's fund is down 31.4% year to date. Long-term shareholders, though, have been rewarded. This American Century offering returned an annual average of 22.2% over the last five years.

One of the most well-known China-focused funds is Matthews China (MCHFX). "We turned cautious in the second half of last year," says manager Richard Gao. He says he grew uneasy with the valuations of Chinese stocks, especially parts of the real estate market (a sector which has since seen a big pullback). Even though Gao anticipated some of the troubles, his fund couldn't get out of the way. It has lost 28% this year, a setback indicative of the hazards of country-specific funds. Gao, though, has reason to believe things will get better.

He argues that the hype surrounding the Olympics was overblown, as was the notion of a post-Olympics letdown. The Games, he says, will have a tiny effect on China's bottom line. Meanwhile, inflation has started to come down as commodity prices ease. The twitchiest speculators have been weeded out of parts of the market. And China's government is taking a proactive stance. "I think we are going to see a change in attitude," says Gao. "In past months the central government had the attitude that it needed to control inflation and keep the economy from overheating." Now, he adds, "we are seeing the central government signal that it is going to be more focused on economic growth." Like Ribeiro, Gao expects a stimulus package soon.

Gao has been positioning his portfolio around a domestic consumption theme fueled by steady wage growth. He is shying away from companies that got a bounce from frothy increases in commodities. Instead, he likes well-run businesses that will benefit from middle-class spending growth. China Mobile is a top holding. So, too, is car maker Dongfeng Motor. Matthews China has returned an annual average of 23.4% over the last five years. That's good enough for Morningstar to rank it among the top 4% of peers.

Gao isn't prepared to make rosy prognostications. "I don't have a crystal ball," he says. "It's very hard to call a bottom." In any case, China should be an important component of your international holdings. Yes, it may be volatile. But the long-term trends are too compelling to ignore. Long after the hot money has headed for the exits, patient investors will be rewarded for sticking it out. "The stocks are looking more and more reasonable," says Gao.