If you saw the Olympics, then you glimpsed China's potential. At least, former British Prime Minister Tony Blair did. In a recent Wall Street Journal editorial, Blair wrote that he observed "a confidence, an optimism, a lack of the cynical, and a presence of the spirit of get up and go, that reminded me greatly of the U.S. at its best and any country on its way forward."

Even NBA star Dwyane Wade was an admirer, calling the National Stadium (a.k.a. the Bird's Nest) "the best building I've ever seen."

It's important to remember
Keep in mind, however, that the Olympics were held in Beijing. Few other cities in China are home to so many architectural marvels, such a developed economy, and access to such a variety of imported goods -- and that means great growth opportunities.

When our Motley Fool Global Gains team traveled to China last summer, we discovered that in a factory town in the west of China -- just an hour outside of Xi'an -- you still can't get a can of Coke. That's despite Coca-Cola (NYSE:KO) being a major Olympic sponsor, hiring Yao Ming to be its spokesman, and spending a hefty sum to distribute product in China.

Then you have the revelations wrought by disaster. Many schools that collapsed during the earthquake earlier this year were not constructed to code with sound materials. A recent fire at a chemical plant in Gunagxi burned for more than seven hours -- killing 20 people and injuring 60 -- likely because the plant had no fire safety equipment.

In other words, there are significant opportunities for both a multinational like Honeywell (NYSE:HON) and a smaller domestic player such as China Fire & Security (NASDAQ:CFSG) to bring factories, plants, and other facilities up to code. Similarly, concrete industry players such as Cemex (NYSE:CX) and KHD Kumboldt Wedag have a significant opportunity as China looks to upgrade the quality of its construction (though Cemex doesn’t yet believe it has ample pricing power in that country).

Yet there are significant opportunities in infrastructure as regional cities grow to resemble Beijing more and more.

Not everybody thinks that way
China, however, has its detractors. There are political opponents who legitimately criticize a repressive regime for its stances on free speech, religion, Darfur, and Tibet. Then there are business skeptics who legitimately fear that internal controls at Chinese companies are lacking, and that related-party transactions between Chinese entrepreneurs are too prevalent. Finally, there are folks who just don't want to get involved. I spoke to a hedge fund manager the other day who won't even consider China ideas, because he'll only invest in companies he "can knock the doors down on personally."

None of these groups are willing to invest in China, but I remain a believer.

The question is: Are you?
If not, you should be. China has its problems -- there's no getting around that.

As Prime Minister Blair wrote, "No sensible Chinese person -- including the country's leadership -- doubts there remain issues of human rights and political and religious freedom to be resolved." But like Prime Minster Blair, I believe that we -- as both investors and world citizens -- should not judge China on how far it has to go to meet our "Western standards," but rather how far it has come, and how much potential it has to be an economic and political friend and ally of the United States.

This is a country whose near-10% annual GDP growth over the past 25 years has lifted more people out of poverty than any other time in history, and whose current "Go West" policy has the potential to further modernize a largely inefficient and agrarian economy. It's also working to improve its environmental and corporate governance standards.

As Charlie Munger told shareholders at the 2008 Berkshire Hathaway (NYSE:BRK-B) annual meeting, when questioned about the ethics of investing in PetroChina: "China is moving in the right direction." Warren Buffett also added that he was excited about the company's acquisition of Iscar partly because of its significant presence in China. "The Chinese people," he said, "are starting to be unleashed and their potential is starting to be tapped," and I assume we'll see Berkshire look even harder at China going forward.

That leaves you two choices
Thus, you have two choices when it comes to investing in China and profiting from the country's enormous potential.

  1. You can apply the same set of standards to Chinese companies that you do to U.S. companies, avoiding those with convoluted ownership structures or ones that came public via reverse mergers. Though this is the safest route, it stands to leave you on the sidelines as China continues to grow and small companies with access to Western capital consolidate their industries and expand from regional players to nationwide giants.
  2. Or you can endeavor to learn as much as you can about China and its culture, perhaps even traveling there to knock on doors, and then modify your investment criteria to be more applicable to analyzing Chinese businesses specifically. When valuing Chinese companies, it also pays to account for unforeseen risk by applying higher discount rates to future cash flows and demanding a greater margin of safety when you invest.

While this strategy will open up more China opportunities, it will not give you carte blanche. Our Global Gains team has been hesitant about buying Baidu.com (NASDAQ:BIDU) because of the stock's tenuous valuation and management's unwillingness to take a meeting.

Why I prefer door No. 2
That said, this second mind-set will get you into more Chinese opportunities earlier rather than later, and you can feel comfortable that China is striving to improve best practices and become more sensitive to Western interests. Though it takes some effort and you may see more volatility as a result, it should pay off substantially in the end -- and I suspect Prime Minister Blair, Mr. Buffett, and Mr. Munger share that perspective.

That's how we're approaching China at Motley Fool Global Gains, as we’re set to travel to the country again in July to meet with a group of carefully chosen companies. You can get all of our notes from those meetings and the rest of our observations from the trip simply by entering your email address in the box below.

This article was first published on Aug. 29, 2008. It has been updated.

Tim Hanson owns shares of China Fire and Berkshire Hathaway. KHD and Cemex are Motley Fool Global Gains recommendations. China Fire is a former Global Gains recommendation. Cemex and Berkshire are Stock Advisor picks. Berkshire and Coke are Inside Value selections. Baidu is a Rule Breakers pick. The Motley Fool owns shares of Berkshire, KHD, and Cemex and has a verifiable disclosure policy.