Scaling the Great Wall

Not that China hasn't taken the words of Deng Xiaoping to heart. The former leader began steering his country toward a market economy in 1979, when he spearheaded the opening of its state-planned system with the oft-echoed "to get rich is glorious." Less than three decades later, cities like Shanghai, Guangzhou and Beijing sport spectacular high-rises, bustling shopping arcades and a burgeoning middle class.

The growth of China's gross domestic product — the market value of all goods and services produced in the country — bears out the transformation. GDP expanded 9.4% in 2005, vs. an estimated 3.6% for the U.S. According to the State Information Center, China's government-run information bureau, GDP will grow between 8.3% and 9.3% this year. The Chinese economy, with an annual GDP in the ballpark of $2 trillion, now ranks fourth behind the U.S., Japan and Germany.

But big-picture economic figures don't necessarily jibe with small-scale investment returns, warns Bill Rocco, an analyst with Chicago-based mutual-fund tracking service Morningstar.

"To a certain extent, the China story is easy to absorb," says Rocco. "It's the most populous country in the world; it's moving rapidly up the economic ladder; it's going from bikes to cars. But it's tricky because that doesn't get to the point that a fast-growing economy means your investment is going to do well."

Unlike U.S. companies, whose investment-worthiness is determined to a large degree by financial performance, many factors beyond quarterly numbers influence the stock prices of publicly traded Chinese companies. Political upheaval in Beijing, for example, can have vast repercussions for a clothing company listed in Hong Kong. Human-rights protests can still disrupt sales abroad, though much less than shifts in import quotas. In addition, many Chinese companies are still partially state-owned, which can limit where and how management conducts business. The end result often is volatility that isn't necessarily tied to fundamentals.

"These are not stocks to put in your portfolio and forget," writes James MacGregor, author of "One Billion Customers: Lessons From the Front Lines of Doing Business in China," published last October. "They swing wildly based on political and economic news, and their values rarely reflect the underlying company and its fundamentals."

Due to cost, complexity and legal hurdles, buying stocks on foreign exchanges isn't feasible for most individual investors. But if you're willing to stomach the risks of investing in China, about 70 Chinese companies are listed on U.S. exchanges through American depositary receipts, according to the Bank of New York. (ADRs are U.S. listed securities that represent shares of foreign companies.) Many Chinese ADRs trade on the over-the-counter bulletin board rather than on major exchanges.

A few of the names are familiar — some for the wrong reasons. Take CNOOC (CEO), the New York Stock Exchange-listed shares of China National Offshore Oil Corp. CNOOC backed off an $18.5 billion bid for Unocal last August in the face of heavy U.S. political criticism. Unocal was subsequently acquired by Chevron (CVX) for about $17 billion.

Chinese telecom ADRs are especially well-represented. Shares of China Telecom (CHA), China Netcom (CN), China Unicom (CHU) and China Mobile (CHL), which all outpaced the S&P 500 index last year, are available for purchase for the usual brokerage commissions.

Telecommunication is a natural sector to consider when looking at China, which is the biggest subscriber market for mobile phones on the planet. Competition is blunted by the fact that the state retains sizable ownership stakes of its four largest fixed-line and wireless companies, says Ping Zhao, an analyst with the New York capital structure research firm CreditSights. That provides a certain measure of stability — none of these stocks is likely to crash and burn for the simple reason that the Chinese government wouldn't allow it — but it also limits the upside and distorts valuations. More importantly, the government controls the licensing process for the so-called third generation, or 3G, of high-speed data transmissions, the next critical step in the evolution of the market.

"All four carriers are owned by the Chinese government, and the government is extremely concerned about competition at this point," Zhao says. "There's a lot of political deal-making [over the 3G licenses] right now."

After all, getting good information from a ministry run by the Communist Party of China is something no individual investor can accomplish, making the decision to buy or sell shares challenging. That reinforces what MacGregor writes in his book about the risks of doing business in the country: "China has allowed foreigners in only on its own terms, and those terms are often opaque, contradictory and bewildering. All too often, laws are only the law when they benefit China. Negotiations can take forever and the resulting agreements can be promptly ignored. Corruption is frequently the lubricant that greases the wheels of commerce. Business in China has always been conducted behind multiple curtains and amid much subterfuge, and that hasn't changed."

Rather than magnifying the risks of investing in China by buying a single company or sector, Morningstar's Rocco recommends mutual funds — either China-specific funds or foreign funds with significant Chinese holdings. Possibilities include Guinness Atkinson China and Hong Kong (ICHKX), Ivy Pacific Opportunities (IPOVX) and Matthews China (MCHFX). Or consider an exchange-traded fund such as the iShares FTSE/Xinhua China 25 Index Fund (FXI), though Rocco points out that mutual funds can prove cheaper for individual investors committing modest sums than paying brokerage commissions on ETFs.

Not only does putting money into mutual funds, which hold baskets of securities, diversify risk, but funds are equipped to purchase shares on foreign exchanges instead of being limited to ADRs. And if bylaws permit, funds can make bets on exotic derivatives in addition to common shares. Of course, individual investors also benefit from the experience of fund managers and research staff. It's that experience that can prove critical in determining the real valuations of Chinese companies, says Edmund Harriss, the London-based manager of the Guinness Atkinson China and Hong Kong fund.

"We're at a stage again a bit like we were in 2003, where company profits have grown pretty steadily," Harriss says. "Chinese companies are looking pretty cheap, and a valuation gap is emerging." (Harriss has held some of the stocks mentioned in this story in the mutual fund he manages.)

Harriss's assessment doesn't extend to all Chinese stocks. He's skeptical of the wisdom of owning Internet names such as Sina.com (SINA), Baidu.com (BIDU) and Tom Online (TOMO). Their valuations are distorted, he says, because all three stocks are listed in the U.S. and as a result attract a lot of what he thinks is unwarranted attention. The high valuations limit upside potential.

"Get a company that lists on the Nasdaq and suddenly it seems to be worth 20 or 30 times its earnings," he says. "Because it's on Nasdaq and is some sort of funky business, it seems to be worth much more."

A further argument for the value of insider knowledge, Harriss says Internet plays carry the added yet overlooked risk of being beholden to China Mobile, which holds sway over most communications within the country. The partially state-controlled company has acted in the past to delay licenses and to restrict some Internet companies' operations that ran counter to government policy.

Yet Frederick Jiang, a portfolio manager at Waddell & Reed in Overland Park, Kan., says his work on the Ivy Pacific Opportunities fund centers on picking companies like China Mobile that benefit from such monopoly positions.

"Companies like China Life Insurance (LFC) and China Mobile face very little competition and have monopoly pricing power. That's where you want to be," Jiang says. "I pay attention to companies in upstream sectors such as energy. The manufacturing sector is very competitive in China, and so few companies enjoy any advantage there." (Jiang has held some of the stocks mentioned in this story in the mutual fund he manages.)

No matter whose investment thesis catches your eye — and regardless of whether you settle on individual stocks, mutual funds or ETFs — most agree that only a small portion of overall assets should be committed to China.

"My advice for the small investor looking to cash in on China," advises MacGregor, the author, "is to consider your China stock investment to be the speculative part of your portfolio."

Morningstar's Rocco agrees, adding that diversification is the key to playing any rapidly developing but volatile economy like China's.

"People get all heated up about a given market and decide they have to put money in to it," he says. "I get a lot of calls from people who are retired and want to put 30% to 40% of their investments into a given single market, and that's obviously insane. This is a very specialized investment for a certain kind of investor."