3 China Profit Plays

If you're like most U.S. investors I meet, you want to invest in China, but you don't know how. You also fret about the quality of corporate governance, a lack of internal controls, and loose enforcement of accounting standards.

So you've decided that despite the incredible long-term growth opportunity it offers, China is not worth the hassle. Either that or you settled for an index fund like the Xinhua 25 Index (NYSE: FXI  ) .

Let's be frank: Neither of these solutions is a good one. But if you read to the end of this article, I guarantee that you'll be a little more comfortable with investing in China, and more importantly, you'll know three key niches where you should be looking to buy stocks.

But first, why you don't want FXI
The problem with the FXI is that it owns 25 enormous, mature, and generally state-owned Chinese companies such as China Mobile (NYSE: CHL  ) . Thus, they're highly regulated, have little room to grow, and aren't run by executives who are known for their entrepreneurial spirit. Buying these stocks in the hopes of profiting from China's development would be like buying Pfizer (NYSE: PFE  ) , Merck (NYSE: MRK  ) , and GlaxoSmithKline (NYSE: GSK  ) in the hopes of profiting from a breakthrough cancer or AIDS drug.

Sure, you could end up making a little money, but you'd be better off finding the specific biotechs that are focused on the project.

Further, fully one-third of FXI is exposed to Chinese banks. These banks, as directed by the government in order to stimulate the Chinese economy, loaned out more money in the first four months of 2009 than in all of 2008. It's difficult to see growth like that and not conclude that underwriting standards were compromised, which could lead to significant profit hits down the line.

Thus, FXI is the wrong choice when it comes to investing in China. But the good news for you is that I have three far more promising alternatives.

China Profit Play No. 1: Rural China
The Chinese government, if nothing else, is focused on self-preservation. That means keeping most of their people content most of the time. And since most Chinese are still rural Chinese, recent government policies have focused on keeping them content amid the current economic downturn. These have recently included raising the minimum purchasing prices for rice, wheat, and soybeans, as well as introducing a new national health-care plan to strengthen the social safety net.

Thus far, these measures are working. The government expects rural incomes in China to rise 6% this year. That optimism has been corroborated by recent results from fertilizer companies such as China Green Agriculture (AMEX: CGA  ) and Yongye Biotechnology that have topped all expectations due in part to farmers' increasing purchasing power. At Motley Fool Global Gains, we expect these companies and others that sell directly into rural China to continue to post good results.

China Profit Play No. 2: Tier 2 Infrastructure
Quick! Name a city in China!

Chances are you said Beijing or Shanghai, and not Xian, Harbin, or Tianjin despite the fact that all five have populations in the multimillions. That's because while the former are world-famous tier 1 cities in China, the latter are relatively unknown tier 2 cities. But in order to even out development in China, the government has made building infrastructure in these tier 2 cities and making them attractive places to do business a priority. For tier 2, this means more roads, power plants, subways, etc.

But rather than pick a company that builds subways or coal-fired power plants or roads or nuclear power plants, at Global Gains we like companies that work across these niches. That's something like China Fire & Security (Nasdaq: CFSG  ) , which supplies fire detection and extinguishing systems for use in power plants, subways, tunnels, and more.

China Profit Play No. 3: SSE-led Consolidation
The fact is that while China's economy has been growing at a near-10% annual rate for the past 25 years, growth is slowing and the low-hanging fruit when it comes to spurring growth has long since been plucked from the tree. Thus, the government is focused on ways to make the economy ever more efficient. One of the strategies they've hit on is the forced consolidation of small, inefficient state-owned enterprises (SOEs) under private companies that they can count on to do right by workers and wring inefficiency out of operations.

We discovered some of these "chosen few" in the health-care and steel sectors during our last research trip to China, and we dubbed them SSEs, or state-sponsored entrepreneurs. We're keen to invest alongside them because of their good relations with the government and their advantaged position when it comes to acquiring new assets, products, or distribution capacity.

Take the next step
This article has provided you with a few leads on how to make real money from China's growth, but if you're ready for more, I invite you to sign up and join us as our Global Gains research team travels back to China in July to meet with more than a dozen promising companies.

By providing your email address below, you'll receive all of our real-time analysis from the road absolutely free.

Tim Hanson is co-advisor of Motley Fool Global Gains. This will be his third trip to China. You can follow Global Gains' Twitter feed here. Tim owns shares of China Fire & Security and Yongye Biotechnology. China Green Agriculture is a Global Gains recommendation, while China Fire & Security Group is a former selection. Pfizer is an Inside Value pick. The Fool's disclosure policy is on the lookout for beef jerky profit plays and will let you know when it finds one.

Read/Post Comments (14) | Recommend This Article (61)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 30, 2009, at 4:55 PM, kal347 wrote:

    You do the same thing on each China article. Set up FXI as the straw dog so you can promote your own newsletter. But if you are really giving investment advice to your readers, you should inform them of other options, like Mattews China (MCHFX) or Fidelity China Region (FHKCX). Both of these actively managed funds have had excellent returns in the past as well as the present.

  • Report this Comment On June 30, 2009, at 5:38 PM, blaueskobalt wrote:

    The problem is that actively managed funds are always bad advice in the long term. Strong past returns may suggest strong future returns, but the only thing that an actively managed fund guarantees is high fees. Also, when a fund boast strong past returns, it inevitably is forced to change: either because its star analysts get moved/promoted, the pool of money that it manages becomes too large for it to continue doing the same things that led to its success, or other funds starting copying their strategy until it no longer becomes advantageous. It's convenient to think that an actively managed fund offers the best of both worlds (diversification and minimal effort of an index fund with rational, evaluating of individual stock picking), but it really doesn't work out that way--you just end up with high fees cutting into an average return.

  • Report this Comment On June 30, 2009, at 8:20 PM, TMFMmbop wrote:

    We've actually featured MCHFX in our service. It's a reasonable option. CHN is another interesting way to play the consumer space.

    But we do offer unique picks in our service that are not included in either of those funds, mostly because we have been able to do some illuminating due diligence on some very small companies.

    Tim Hanson

  • Report this Comment On June 30, 2009, at 9:27 PM, richie54 wrote:

    Whatever happened to Ctrip, your China star of 2008?

  • Report this Comment On June 30, 2009, at 10:06 PM, Shawnerz wrote:

    This may be a dumb question, but I'll ask it anyway: If these Chinese companies are doing so well domestically, why would they *want* to trade on the American exchange? Are they trying to raise capital any way they can?

  • Report this Comment On June 30, 2009, at 10:21 PM, TMFMmbop wrote:

    @richie54 -- ctrp was never a global gains stock; it's a well-run company, but it had a high valuation and has struggled a little bit as chinese consumer discretionary (travel) spending has fallen off. but we used ctrip to book a bunch of flights within china, and it remains a good site with good service.

    @Shawnerz -- the financial system in china is all state-run and you need state approval to list on the domestic exchange. thus, if you're not a state-owned enterprise or a favored company, it can be extremely difficult to raise capital at reasonable rates. this was particularly true during the 2004-06 period when china was growing quickly, but the state had not yet liberalized its capital raising mechanisms. thus, you had a lot of small chinese companies quickly go public in the US via reverse mergers in order to tap capital to take advantage of china's rapid growth. of course, there were also a lot of bad companies that just wanted to cash in. that's why it's important to exercise discretion when picking among these companies, and why our trips have been so valuable and profitable.

    tim hanson

  • Report this Comment On July 01, 2009, at 7:20 AM, vass08 wrote:

    if i remember correctly GG issued a sell for CSFG a few days ago...

  • Report this Comment On July 01, 2009, at 8:02 AM, pianofritz50 wrote:

    Instead of FXI, also look at the etf PGJ... a more balanced "China Basket"

  • Report this Comment On July 01, 2009, at 10:11 AM, kidchicago2 wrote:

    Wow. I'm a GG subscriber and respect you Tim, but you can't hawk CFSG when your service has a Sell rec on the stock. Please don't let the need to market the service compromise your consistency; it makes you and the service look like every other stock pusher. I think the Fool and Global Gains are better than that.

  • Report this Comment On July 01, 2009, at 10:14 AM, TMFMmbop wrote:

    @kidchicago -- it was a general example of the type of company that works across industrial niches. i didn't think i was hawking it (there's not strong "buy" language around the company, but yes, we sold it due to valuation, which is why its revealed as a former selection in the disclosure.

    thanks for the kind words.

  • Report this Comment On July 01, 2009, at 10:35 AM, kidchicago2 wrote:

    Re-reading the the CFSG section, I see it's carefully phrased, so you're right, "hawking" is not the word I should have used. But if I was reading it cold, without being a subscriber to Global Gains, I'd think you were pointing to CFSG as a stock to buy. There are no other stocks of that "type" listed and no suggestion that CFSG itself may be overvalued. (Although perhaps that's less of a concern now than a few weeks ago.)

    Ultimately, this is a side concern for me though. I love the Global Gains service and have done well by it. I'd highly recommend it to others. I just wish the Fool as an entity was a bit less pushy in its marketing and more careful about mixed signals in its free and subscriber publications. But that's not a problem with Global Gains.

  • Report this Comment On July 01, 2009, at 6:34 PM, memoore10 wrote:

    I concur with kidchicago2, that the CFSG information is a bit misleading. The writeup identifies infrastructure as viable "China play" and then mentions CFSG as a suggestion (?) but not really a recommendation since the service has advised subscribers to sell (shown in the fine print, hmm). Trust and integrity are very important attributes for financial and investment advisers, and I believe that we all have a very sour taste in our mouths after the Bernie Madoff and Allan Stanford stunts. As a potential TMF subscriber I want to feel good about the historical recommendations from TMF newsletters, the TMF articles, and from the feedback from the current subscribers. Given that we all scan information at times I would not expect to have to look at the fine print disclosures at the bottom of the page to see that CFSG is really a SELL. Silly me!

  • Report this Comment On July 06, 2009, at 11:46 AM, ChairmanMAObama wrote:

    Wish our Congress would read any bill that comes thru. Maybe The President also. Not just see what the want. I think one thing is if you buy any thing without doing your own homework and thinking that doesnt make sense, i had better reread the article. Your a fool , not a motley fool. The only stock i have bought thru MF advice was tup thank you MF bought at 14$$$$$

  • Report this Comment On July 06, 2009, at 5:47 PM, wealth10m8 wrote:

    New guy on the block. Am impressed with everyone's knowledgeable, ethical and kind behavior. Hats off to all of you. Look forward to listening and dealing with all of you either through comments or investments.

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