Stocks to Tame the Chinese Dragon

It wasn't too long ago when Alan Greenspan prophesied a "dramatic correction" in the Chinese stock market. In the months since, the Shanghai Composite Index has roller-coastered up and down. It's up a miraculous 30% since mid-May, but has also pulled investors down as much as 10% as well. Investors the world over seem cautiously optimistic. But Greenspan's clearly not the only one thinking such thoughts.

Asia's richest man, Li Ka-shing, echoed similar remarks, dropping the one word that shall not be mentioned. I'll give you a hint: It rhymes with "rubble," and we had a tech one some seven years ago. Further doom was hinted at by the governor of the People's Bank of China, Zhou Xiaochuan.

So, is the Chinese market headed for catastrophe? And are investors with exposure doomed to failure? No, they're not doomed. I'm going to give you stocks that should help you profit, no matter what happens in the near term.

But before we get to the stocks ...
Though investors aren't doomed, the Chinese market is fairly overheated. Millions of Chinese citizens with newfound wealth are buying up stocks of companies they don't understand. According to data from Bloomberg, more than 57 million brokerage accounts were opened in China in the first 11 months of 2007 -- a sum more than 10 times the number opened in all of 2006.

Moreover, the Chinese stock market is valued highly. As of December, the Shanghai Composite was trading for a whopping 46 times earnings -- nearly triple the P/E of the S&P 500.

Dare I say it?
Any correction is not going to last, particularly for companies with solid business models, good leadership, and a manageable capital structure. And that's because China's entire economy is expected to grow between 8% and 9% over the next five to 10 years.

Chinese productivity and export growth should also continue to expand. Meanwhile, a multiplying Chinese middle class will undoubtedly consume, consume, consume.

Regardless of whether China is the leading economic power in years to come, people should feel confident in the nation's ability to grow for the long term and overcome any near-term hiccups. Because it most certainly will.

Stocks that can survive the storm
To find stocks that will profit despite a correction or two, an investor must evaluate a company's business model apart from the rising tide of China's rapid economic growth. Ask yourself whether this business could succeed in a nation that wasn't growing as quickly. Similarly, evaluate the rest of the company as if it were a company in your own backyard. Is it producing free cash flow? Does it have manageable levels of debt? What are its competitive advantages? Are those advantages lasting? And, finally, does it have defensible sources of income?

A stock's exposure to China will only take it so far. It has to be a sound investment first. So I'm going to give you several ideas with promising exposure to the Eastern nation, a proven ability to generate free cash flow, and manageable debt levels:

Solid companies with great opportunity
Rofin-Sinar is a well-known American stock that has China in its crosshairs. While Rofin-Sinar already brings in a substantial amount of its revenues from China and the larger East Asian subcontinent, it has called China its greatest source of growth over the next 10 to 15 years.

China Mobile and China Unicom are two telecom behemoths that will supply the nation's growing thirst for data and wireless connectivity. Meanwhile, NetEase will fuel the nation's growing hunger in gaming and entertainment. Admittedly, China Southern Airlines is burdened heavily with about $7 billion in debt, but as you can imagine, the growth potential for the airline industry in China is massive. The population there is getting wealthier, and the government has told the burgeoning middle class to travel more.

The Foolish bottom line
Perhaps the Chinese market is poised for a correction, perhaps not. Of course, if a correction does come, it might just provide you with a great entry point for one of these stocks.

Regardless, China is growing rapidly, and you won't miss out on the action if you've got a financially sound company with a competitive edge to exploit. These are precisely the stocks we seek out at our Motley Fool Global Gains international investing service. In fact, the Global Gains team recently completed a tour of Latin America's best investing opportunities. Get all of their past updates and the team's best spots for new money now with a free trial.

This article was first published June 1, 2007. It has been updated.

Fool analyst Nick Kapur owns no shares of any company mentioned above. Shanda and NetEase are Rule Breakers recommendations. Rofin-Sinar is a Hidden Gems recommendation. The Fool has a disclosure policy.