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 the driving forces 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
Did these first-time investors truly know what they're buying? Here they were 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."
And in 2008, the Chinese stock market looked a whole lot like tech stocks did in 2001 -- it was down more than 60%!
China: The next wonder of the world
Although the excitement surrounding the Chinese market is subsiding, at current prices, China stocks are starting to look like very promising long-term investments. After all, this is a country that has posted nearly 9% annual growth in gross domestic product over the past five years. And despite the recent drop, an investor who threw $10,000 at the iShares FTSE/Xinhua China 25 Index
In other words, it was unbelievable.
And if you're thinking that the boom and bust in China's stock market resembles quite closely the boom and bust we saw on the Nasdaq in 2000, well, you're right. But if you took advantage of that downturn to buy long-term winners such as Apple
History repeats itself
So, while the China market is coming to terms with reality, there are individual companies that will continue to profit from this enormous economic growth engine. Remember: No matter what its relatively immature domestic stock market says, the opportunities in China are huge. If they weren't, companies such as Yum! Brands, Caterpillar
That number has only increased.
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 -- even as the market drops.
That means focusing on quality companies and buying on dips -- like the one we're seeing today -- and having the patience to hold them for the long term.
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. We travel to China each year for research and have already identified a number of promising opportunities.
This article was first published on May 21, 2007. It has been updated.
Tim Hanson does not own shares of any company mentioned. Huaneng Power is both a Motley Fool Rule Breakers and an Income Investor recommendation. Apple is a Stock Advisor pick. The Fool's disclosure policy never drops it, even when it's hot.