Peter Lynch is perhaps most 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."
Yet a recent AP headline revealed some of what drove 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
Did these first-time investors truly know what they were 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 was the wonder more recently -- and for good reason. This is a country that has posted nearly 9% annual GDP growth over the past five years. Through the spring of this year, an investor who threw $10,000 at the iShares FTSE/Xinhua China 25 Index when it started trading in October 2004 would have earned better than 34% annual returns.
That was pretty similar performance to the 124% return that the Nasdaq 100 index offered from March 1999 to March 2000, when Flextronics (Nasdaq: FLEX ) , Altera (Nasdaq: ALTR ) , Sirius XM (Nasdaq: SIRI ) , and Yahoo! (Nasdaq: YHOO ) were all up 100% or more.
Yet the Nasdaq 100 is down more than 50% since, and thanks to the current global financial crisis, the China 25 index is almost back to where it was in 2004.
History repeats itself
It's hard to say whether such a prolonged drop is in the cards for China. Some of the economic data coming out of China is regarded as questionable, and it's almost impossible to predict the effects that global politics will have on the Chinese economy.
That said, the opportunity in China is clearly huge. If it weren't, companies such as Hewlett-Packard (NYSE: HPQ ) , Deere (NYSE: DE ) , Google (Nasdaq: GOOG ) , and many more 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 gotten bigger.
A growing $75 billion opportunity
Just as the potential rewards of investing in China make it imperative that U.S. companies invest there, it is imperative that individual U.S. investors put some money to work there as well. But -- and this is the crucial point -- we must do so without ignoring the time-honored principles of investing in stocks.
That means 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 all the way around the world? We put that question to Oakmark International manager David Herro recently, and here's what 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."
The current drop in Chinese stock prices represents a significant long-term opportunity for the savvy American. If you're that savvy investor and would 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.
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This article was first published on May 21, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. Google is a Motley Fool Rule Breakers recommendation. The Fool's disclosure policy never drops it, even if it's hot.