Stocks to Tame the Chinese Dragon

Not too long ago, 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 51% since mid-May, but has also pulled investors down as much as 7%. 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 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, a sum four times the number opened in all of 2006.

Moreover, the Chinese stock market is valued highly -- with the Shangai composite valued at more than 50 times earnings. That's more three times the P/E of the S&P 500!

Dare I say it?
Any correction won't last, particularly for companies with solid business models, good leadership, and a manageable capital structure. After all, China's entire economy is expected to grow between 8% and 9% 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
The hottest name of the lot is definitely Baidu.com. The company is directly challenging Google (NASDAQ:GOOG) for search supremacy in the Eastern nation, and it seems to be doing quite a good job of it. While the stock is up more than 250% in the past year, and competition remains fierce, this is still a wide-open frontier, and it will be explosively profitable for the winner.

CNET and Avaya are both solidly American companies, looking to reap the benefits of a tech-enabled culture spreading throughout a population of 1.3 billion. Avaya should take a growing chunk of its revenues from China, as local companies attempt to build their "telepresence." Meanwhile, CNET has made numerous inroads in China, connecting with techies and providing them with up-to-date industry knowledge.

Lastly, Sinopec is a chemical company involved in synthetics and other refined petroleum products. It can challenge the global giants of these products, including ExxonMobil (NYSE:XOM) and BASF, on the company's home turf.

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 recently completed a tour of some of Asia's best investing opportunities. If you're interested, you can take a free look at their picks and research. Just click here for a zero-commitment, 30-day trial.

This article was first published June 1, 2007. It has been updated.

Fool analyst Nick Kapur owns no shares of any company mentioned above. Baidu.com and CNET are Rule Breakers recommendations. The Fool has a disclosure policy.