Beware the Dragon's Teeth

Despite its growing economic power and rising importance in world markets, I'm still leery about investing in China. An increasing number of risk factors should encourage Fools to exercise caution when investing, whether in Chinese companies or domestic firms that rely on China for much of their business.

Political obstacles
For one thing, I'm not sure the government has truly established its willingness to let capitalism thrive in a communist country. This isn't political commentary, just an investment reality, though there are many who disagree. Like Russia before it, the semblance of a market economy can quickly collapse when the state steps in to seize the opportunities whose profits it wants to monopolize.

The state can also suddenly change the rules of any given economic game. That's what happened to Chinese Internet firms TOM Online (Nasdaq: TOMO  ) and Sina (Nasdaq: SINA  ) last year, when the Ministry of Information directed China Mobile (NYSE: CHL  ) to change the imposition and collection of various fees. Both stocks tumbled, suddenly denied large swaths of revenue.

Although the government is permitting certain market reforms, it hasn't much loosened its iron grip. Rather than abandon a potentially lucrative market, Google (Nasdaq: GOOG  ) ultimately kowtowed to the government's mandate to limit searches for subjects the state didn't like. The Chinese video game industry is also learning that it might have to limit the amount of fun it provides players, as the government imposes a moratorium on new Internet cafes.

A toxic revelation
The latest China-related scare revolves around quality control issues. Chemicals used in brake fluid and antifreeze were found in toothpaste made in China. The export companies changed the shipping manifests so that the chemical appeared to be a medicinally approved substance instead of the poisonous coolant. The FDA was concerned enough to urge consumers to throw away any tube of toothpaste that says "Made in China." Chinese-made pet food also has been found to contain dangerous chemical. Manufacturers there added the chemical melamine -- used as a binding agent and flame retardant -- to vegetable proteins, which were then used in feed for pets, hogs, chickens, and fish. Melamine is also used as a fertilizer in some countries, but not here in the U.S.

The latest example of Chinese companies short-circuiting the country's alleged quality control mechanisms involves the use of lead paint on toys sold by RC2 (Nasdaq: RCRC  ) , the maker of the popular Thomas the Tank Engine. Apparently without the company's knowledge, its Chinese manufacturer switched the chemical formulation on the paint the Thomas toys use. After a routine check by RC2 discovered the lead paint, the company notified the Consumer Product Safety Commission and announced a voluntary recall of some 1.5 million lead-tainted toys.

The fallout from the incident has been predictable, with consumers filing a class action lawsuit and the media whipping up hysteria. The New York Times has run no less than three major articles on the issue, along with a scathing op-ed piece that suggests that the newspaper may very well be on a crusade to vilify companies doing business in or with China.

Investing without blinders
While there's clearly a xenophobic component to this backlash, investors need to be aware of the risks inherent in putting their money into emerging markets. Whether it's risk from fickle government policy, quality control issues, or the next unknown crisis, Fools should have both eyes open to invest with confidence.

China's still too much of a crapshoot for me to put my dollars to work there. True, I might lose out on its rising airline industry, and ancillary businesses such as the travel sites that support it. I might also miss the opportunity to make a profit on the growing video game industry there. Still, the money I might make can't outweigh my doubts about just how level the country's playing field may be.

Investors should also be wary of American companies that outsource facilities and processes to China. So far, the lead paint issue hasn't hit RC2's stock, but if a class action lawsuit costs the company millions of dollars in claims, that hurt will flow right to the bottom line -- and out to investors everywhere.

One Fool's thoughts
Once upon a time, "Made in Japan" was a euphemism for shoddy products. Not anymore. Right now, China seems to be developing the same reputation. For our own health and safety, not to mention the profits of the companies in which we invest, we need to decide whether "Made in China" is a warning label worth the risk.

China Mobile is a recommendation of Motley Fool Global Gains. Discover more appealing investment opportunities abroad with a free 30-day trial subscription.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. Sina and TOM Online are recommendations of Motley Fool Stock Advisor. RC2 is a recommendation of Motley Fool Hidden Gems. The Fool's disclosure policy's kung fu is strong.


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