What happens when you combine too much money with too little scrutiny? You get blow-ups. And that's exactly what some experts predicted for Chinese stocks at a recent conference hosted by Roth Capital.
Yes, the Chinese economy has a very bright future. Look for the country to continue what Roth has already called "the greatest sustained economic advance of the greatest number of people in recorded history -- 9.7% growth for 26 years." But on a stock-by-stock basis, there are a lot of bad trades to be made given current valuations. While the comparisons with the Internet bubble are imprecise, the fact remains that a rising tide does not lift all boats.
Hot money, hot stocks
A lot of money has flowed into Chinese stocks. The Dow Jones China index, for example, trades for more than 45 times earnings and 5.5 times book value. To give you an idea of how rich that is, only 123 stocks on our domestic exchanges are as pricey, including Monsanto (NYSE: MON ) , Celgene (Nasdaq: CELG ) , and Allergan (NYSE: AGN ) .
What's more, those multiples may understate the premium on Chinese stocks if you're skeptical -- as I am -- that reliable financial controls are in place at all 1,100 companies the index tracks.
Yet there's a reason why the "China Track" was among the hottest tickets at the Roth Conference -- tiny Chinese company after tiny Chinese company presented to packed rooms of professional investors. After all, there's still a lot of money to be made there.
The $64,000 question is: Where?
We'll draw you a map
For hints about the next phase in China's economic development, take a look at the Enterprise Income Tax Law the government passed in March, which goes into effect Jan. 1, 2008. It sets a new unified tax rate of 25% and retains the reduced 15% tax rate for new or high-technology businesses.
It also, according to tax advisor Deloitte, offers important incentives to encourage "major infrastructure, environmental, and agricultural projects," growth "in the Western region," and the move from "an export-oriented economy to a domestically driven economy."
In other words, it's time to figure out who benefits from a modernizing country with a strong and growing middle class.
If you immediately thought of Starbucks (Nasdaq: SBUX ) and Nike (NYSE: NKE ) , then we're seeing eye to eye. But businesses based in the West aren't the only -- or best -- way to profit from China's growth. That's because the Chinese government is focused on protecting its domestic enterprises and ensuring that they benefit most from China's success.
Tiny China Fire & Security, for example, is just a $330 million company, yet it's helping the government write new industrial fire codes and winning big contracts from giants such as PetroChina, Wuhan Iron & Steel, and Handan Iron & Steel as they build out infrastructure in the west. Multinationals such as Honeywell simply don't have the same connections.
That's a big advantage for a small company to have, and it's an advantage unique to Chinese firms operating in China. What's more, China Fire is up nearly 40% since our Motley Fool Global Gains team highlighted it in our July report focusing on Asia, "11 Plays to Profit."
Find your next buy
Despite the hot returns of the past few years, every investor should be taking a good, long look at Chinese stocks. That doesn't mean buying the index, but it does mean taking advantage of select opportunities and using volatility to build out meaningful positions at lower cost bases.
Our team at Motley Fool Global Gains is focused on doing just that, and we recently returned from a research trip to China, India, Taiwan, Mongolia, and Macau.
You can see our best ideas from the trip, as well as our top picks for new money now, by joining Global Gains free for 30 days. You can also subscribe and get a gratis copy of our new Asia Rising report.
This article was originally published Sept. 13, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. Starbucks is a Motley Fool Stock Advisor recommendation. The Fool's disclosure policy thinks you've seen enough.