An Opportunity That's Too Large to Ignore

New data shows that over the past three years, China doubled the amount of oil it imports from Saudi Arabia, to exceed 1 million barrels per day in 2009. Meanwhile, the U.S. dropped below the same threshold for the first time since 1988. That is but one of several 2009 milestones marking the eastward rebalancing in the world economy:

  • The Chinese car market grew by 46%, to become the largest car market in the world, ahead of the United Sates.
  • China was the largest source of foreign initial public offerings on U.S. exchanges last year, with 11 of 14 listings. Over the past five years, Chinese company initial public offerings raised $210 billion worldwide; American companies raised just $184 billion.
  • China passed Germany to become the world's largest exporter.
  • Japan just barely clung to its status as the world's second-largest economy in 2009, ahead of China. That status is unlikely to last another year. Adjusting for purchasing-power parity, China passed Japan some years ago.

"The Decade the World Tilted East"
In light of those facts, it's easy to see why Harvard financial historian Niall Ferguson recently penned an article in the Financial Times titled "The Decade the World Tilted East." China's economic achievements over the past three decades have been nothing short of remarkable. The rebalancing that is occurring looks unlikely to reverse; a relative decline of U.S. economic standing appears inevitable. However, it is by no means assured that China will leap past the U.S. in absolute terms on a precise schedule that simply extrapolates recent growth rates.

China is an investors' conundrum that combines extraordinary potential with significant risks, including ethnic tensions, corruption, and enormous disparities in wealth and income. This is no different for individual investors or multinational companies. Take mining giant Rio Tinto (NYSE: RTP  ) , for example. China is the company's largest market for iron ore; meanwhile, four former employees in that activity now sit in Chinese prisons, sentenced to a combined 39 years on bribery and espionage charges.

Corruption: One risk among several
I'm not disputing the verdict of the Chinese court, but corruption is endemic in China, and the steel sector is no exception. Transparency International ranks China 79th out of 140 nations in the 2009 Corruption Perceptions Index, at the same level as Burkina Faso, Trinidad and Tobago, and Swaziland.

Despite such risks, most participants are seduced by the self-explanatory growth story and focus on promise without enough regard for pitfalls. This can produce vertigo-inducing valuations, particularly for some of the better-known names, such as search company Baidu.com (price-to-earnings multiple: 58.3). However, with the MSCI Broad China Index down more than 9% year to date, many Chinese shares look reasonably priced at a glance:

Stock

Sector

Price-to-Earnings Multiple

Shanda Interactive (Nasdaq: SNDA  )

Technology

13.2

NetEase.com (Nasdaq: NTES  )

Technology

12.0

General Steel Holdings (NYSE: GSI  )

Basic materials

10.7

Jinpan International (Nasdaq: JST  )

Technology

9.2

China Natural Gas (Nasdaq: CHNG  )

Utilities

7.4

Fuqi International (Nasdaq: FUQI  )

Consumer goods

5.6

Average P/E Multiple, Chinese Shares Traded on Major U.S. Exchanges**

--

19.2

Median P/E Multiple, Chinese Shares Traded on Major U.S. Exchanges

 

11.8

*Based on companies' estimated earnings per share for the current fiscal year. **Based on the subset of companies for which the P/E multiple is available (107 of 184 companies). Source: Capital IQ, a division of Standard & Poor's.

Long-term participant, short-term contrarian
I think that to balance risk and reward, the most sensible approach to investing in China combines:

  • A willingness to participate in China's long-term growth. Given the size of the opportunity, excluding China from one's portfolio looks like the greater risk. It is completely sensible for investors to seek exposure to China.
  • Tactical contrarianism/opportunism. China's economic rise isn't preordained, nor will it necessarily occur at a linear 8% to 10% growth rate. Canny investors will seek to build their exposure during periods in which the Middle Kingdom encounters setbacks, investor sentiment is negative, and valuations are attractive.

Another possible implementation of this opportunistic approach is to focus on companies or industries that are relatively less high-profile. Everyone has read the accounts and seen pictures of gleaming skylines in coastal cities that are at the fulcrum of China's development. But other things are taking place all over the country, in places that most investors would never dream of visiting.

Venturing off the beaten path
Motley Fool Global Gains co-advisor Tim Hanson traveled to China on a research trip and spent time looking for opportunities in rural China -- including time on the ground in Inner Mongolia. One of the companies he discovered there was a small fertilizer producer, Yongye International, which has a huge potential market and is well-run. And, best of all, the stock was inexpensive. Apparently, fertilizer doesn't stir investors' imaginations in the same way online gaming or paid search does.

China's growth story will probably play out for years, with spurts and slowdowns along the way. So if you don't own a piece of it yet, you haven't missed the boat. However, it pays to begin implementing your China strategy within your portfolio today -- the opportunity is too large not to give it full consideration. If you'd like to see where the Global Gains team has been placing its bets in China, take advantage of a 30-day free trial now. You'll be able to see every stock pick, including a Chinese stock Tim selected that has gained more than 400% and is still one of his Best Buys now.

Fool contributor Alex Dumortier loves macro-themed investing; he has no beneficial interest in any of the stocks mentioned in this article. NetEase.com and Shanda Interactive Entertainment are Motley Fool Rule Breakers recommendations. General Steel Holdings is a Global Gains pick. Jinpan International is a Motley Fool Hidden Gems recommendation. The Motley Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (10)

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 May 10, 2010, at 4:27 PM, applegate888 wrote:

    buy

  • Report this Comment On June 07, 2010, at 6:35 AM, Sleddawg63 wrote:

    Why is FUQI on this list? Potential scam, at least gawd-aweful accounting practices. Three months later they still cannot release the real numbers.

  • Report this Comment On July 01, 2010, at 7:47 AM, tselliot wrote:

    Potential scam? I would like to kn ow to stear clear... Sleddawg, what do you know?

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