Stocks to Tame the Chinese Dragon

It wasn't too long ago that Alan Greenspan prophesied a "dramatic correction" in the Chinese stock market. In the months since, the Shanghai Composite Index has roller-coastered up and down. It's up a miraculous 25% since mid-May but has also pulled investors down as much as 7% as well. Investors the world over seem nervous. Greenspan's clearly not the only one thinking such thoughts.

Asia's richest man, Li Ka-shing, echoed similar remarks, dropping the one word that shall not be mentioned. I'll give you a hint: It rhymes with "rubble," and we had a tech one some six years ago. Further doom was hinted at by the governor of the People's Bank of China, Zhou Xiaochuan.

So is the Chinese market headed for catastrophe? And are investors with exposure doomed to failure? No, they're not doomed. I'm going to give you a handful of stocks that will help you profit, no matter what happens in the near term.

But before we get to the stocks ...
Though investors aren't doomed, the Chinese market is fairly overheated. Millions of Chinese citizens with newfound wealth are buying up stocks of companies they don't understand. More than 20 million brokerage accounts opened in China between January and May, four times the number opened in all of 2006.

Moreover, China's 300 largest companies are valued at approximately 50 times earnings, according to Bloomberg, which makes the Chinese market the most expensive in the world. The Chinese stock market was valued at roughly 40 times earnings this past May -- and probably is higher today given the recent upsurge. For context, that's more than double the earnings multiple of the stocks that make up the S&P 500-tracking SPDRs (AMEX:SPY).

Dare I say it?
But any correction is not going to last, particularly for companies with solid business models, good leadership, and a manageable capital structure. And that's because China's entire economy is expected to grow between 8% and 9% a year over the next five to 10 years.

Chinese productivity and export growth should also continue to expand. Meanwhile, a multiplying Chinese middle class will undoubtedly consume, consume, consume.

Regardless of whether China is the leading economic power in years to come, people should feel confident in the nation's ability to grow for the long term and overcome any near-term hiccups. Because it most certainly will.

Stocks that can survive the storm
To find stocks that will profit despite a correction or two, an investor must evaluate a company's business model apart from the rising tide of China's rapid economic growth. Ask yourself whether this business could succeed in a nation that wasn't growing as quickly. Similarly, evaluate the rest of the company as if it were a company in your own backyard. Is it producing free cash flow? Does it have manageable levels of debt? What are its competitive advantages? Are those advantages lasting? And finally, does it have defensible sources of income?

A stock's exposure to China will only take it so far. It has to be a sound investment first. So I'm going to give you five stocks with promising exposure to the Eastern nation, a proven ability to generate free cash flow, and manageable debt levels:

Solid companies with great opportunity
Corning and MasterCard are two American stocks that have China in their crosshairs. While Corning brings in just 3.8% of its revenue from China, the figure is rising as the result of Corning's more than $3 billion multi-industry investment in the country.

MasterCard use has been growing rapidly in China since 2000 alongside the rising middle and wealthy classes. The company's working to implement its PayPass system across Asia and recently released a study documenting just what a huge opportunity "China's affluent" present to the company.

Finally, American Oriental Bioengineering is one of my favorite growth picks going into the next few years. The company offers plant-based and organic remedies to the more than 1 billion Chinese citizens. The market for these products is there without a doubt, and the company is reasonably priced relative to its growth potential and sitting on a very healthy balance sheet.

The Foolish bottom line
Perhaps the Chinese market is poised for a correction, perhaps not. Of course, if a correction does come, it might just provide you with a great entry point for one of these stocks.

Regardless, China is growing rapidly, and you won't miss out on the action if you've got a financially sound company with a competitive edge to exploit. These are precisely the stocks we seek out at our Motley Fool Global Gains international investing service. In fact, the Global Gains team just completed a pan-Pacific tour of some of Asia's best investing opportunities. If you're interested in taking a free look at their picks and research click here for a zero commitment 30-day trial.

This article was first published as "7 Stocks to Tame the Chinese Dragon" on June 1, 2007. It has been updated.

Fool analyst Nick Kapur owns no shares of any company mentioned above. MasterCard is a former Inside Value recommendation. The Fool has a disclosure policy.