Peter Lynch is famous for advising investors to "buy what you know." But "knowing," for Lynch, is not simply having a favorite restaurant or store. In the introduction to the millennium edition of One Up on Wall Street, he writes, "Never invest in any company before you've done the homework on the company's earnings prospects, financial condition, competitive position, plans for expansion, and so forth."
In other words, there's a lot more to "know."
An AP headline revealed some of what's behind the frenzy that pushed the Shanghai Composite Index up 130% in 2006 and 97% in 2007: "1st Time Investors Buy Up Chinese Stocks."
1999 all over again
Do these first-time investors truly know what they're buying? Here they are in their own words: "'We can still make money,' Ding [Xiurui] said. ... Asked what stocks she would buy, Ding said, 'I don't know. I'm still learning.'"
If that sounds familiar, it should. Here's Steven Leeb writing about the tech bubble in his book, The Coming Economic Collapse: "Millions upon millions of investors ignored time-honored principles for investing in stocks, such as due diligence and fundamental analysis, and began to buy and sell out of emotion. Believing in the wonders of technology, they rushed to buy technology and Internet stocks like rats following a Wall Street pied piper."
China: The next wonder of the world
Just as technology was the wonder 10 years ago, China is the wonder today -- and for good reason. This is a country that has posted nearly 9% annual GDP growth over the past five years. An investor who threw $10,000 at the iShares FTSE/Xinhua China 25 Index (NYSE: FXI ) when it started trading in October 2004 would have nearly $29,000 today. That's a 38% annual rate of return from a passive fund that's invested in giants such as Aluminum Corp. of China (NYSE: ACH ) and Huaneng Power (NYSE: HNP ) .
In other words, it's almost unbelievable.
But it's also pretty similar to the 124% return that the Nasdaq 100 index offered from March 1999 to March 2000. And even major holdings in tech giants such as Adobe (Nasdaq: ADBE ) and Dell (Nasdaq: DELL ) couldn't save that index from the 50% drop it's experienced since.
History repeats itself
It's hard to say whether such a prolonged drop is in the cards for China. Some of the country's economic data is regarded as questionable, and it's almost impossible to predict the effects that global politics will have on the economy.
That said, the opportunity in China is clearly huge. If it weren't, companies such as Yum! Brands, Caterpillar (NYSE: CAT ) , and many others wouldn't be investing so heavily in the country. According to the U.S. Chamber of Commerce, sales by American companies in China topped $75 billion in 2004.
That number has only increased.
A growing $75 billion opportunity
Just as the potential rewards of investing in China make it imperative for U.S. companies to invest there, individual U.S. investors must put some money to work there as well. But -- and this is the crucial point -- we must do so without ignoring traditional, proven principles of investing in stocks.
Those principles include buying quality companies at good prices and having the patience to hold them for the long term. How does one do that when the companies are operating on the other side of the world?
We put that question to Oakmark International Manager David Herro recently. He said, "That's why I'm in Japan right now with two other analysts. We're visiting companies. Our team spends a lot of time overseas trying to understand how company managements think."
If you'd like to invest some of your portfolio in a few carefully chosen Chinese companies but don't have the time to travel to China or don't want to pay the fees associated with active mutual fund management, consider joining our Motley Fool Global Gains international investing service.
Global Gains advisor Bill Mann recently returned from meetings in China, Macau, India, and Taiwan and has identified a number of promising opportunities. You can read his updates, research, and specific recommendations by becoming a member of Global Gains free for 30 days. There is no obligation to subscribe. Click here for more information.
This article was first published on May 21, 2007. It has been updated.
Fool contributor Tim Hanson does not own shares of any company mentioned. Huaneng Power is a Motley Fool Rule Breakers recommendation. Dell is a Stock Advisor and Inside Value recommendation. The Fool's disclosure policy never drops it, even when it's hot.