If you're like most U.S. investors I meet, you want to invest in China, but you don't know how. You also fret about the quality of corporate governance, a lack of internal controls, and loose enforcement of accounting standards.
So you've decided that despite the incredible long-term growth opportunity it offers, China is not worth the hassle. Either that or you settled for an exchange-traded fund that makes China a part of its portfolio ... like the Xinhua 25 Index (FXI).
Let's be frank: Neither of these solutions is a good one. But if you read to the end of this article, I guarantee that you'll be a little more comfortable with investing in China, and more importantly, you'll know three key niches where you should be looking to buy stocks.
But first, why you don't want FXI
The problem with the FXI is that it owns 25 enormous, mature, and generally state-owned Chinese companies such as PetroChina
Buying these stocks in the hopes of profiting from China's development would be like buying Johnson & Johnson
Sure, you could end up making a little money, but you'd be better off finding the specific biotechs that are focused on the project.
Further, fully one-third of FXI is exposed to Chinese banks. These banks, as directed by the government in order to stimulate the Chinese economy, loaned out more money in the first four months of 2009 than in all of 2008. It's difficult to see growth like that and not conclude that underwriting standards were compromised, which could lead to significant profit hits down the line.
Thus, FXI is the wrong choice when it comes to investing in China. But the good news for you is that I have three far more promising alternatives.
China profit play No. 1: rural China
The Chinese government, if nothing else, is focused on self-preservation. That means keeping most of their people content most of the time. And since most Chinese are still rural Chinese, recent government policies have focused on keeping them content amid the economic downturn. These have included raising the minimum purchasing prices for rice, wheat, and soybeans, as well as introducing a new national health-care plan to strengthen the social safety net.
Thus far, these measures are working. The government expects rural incomes in China to rise 6% this year. That optimism has been corroborated by recent results from fertilizer companies such as China Green Agriculture and Yongye International that have topped all expectations due in part to farmers' increasing purchasing power. At Motley Fool Global Gains, we expect these companies and others that sell directly into rural China to continue to post good results.
China profit play No. 2: tier 2 infrastructure
Quick! Name a city in China!
Chances are you said Beijing or Shanghai, and not Xian, Harbin, or Tianjin, despite the fact that all five have populations in the multimillions. That's because while the former are world-famous tier 1 cities in China, the latter are relatively unknown tier 2 cities. But in order to even out development in China, the government has made it a priority to build infrastructure in these tier 2 cities and make them attractive places to do business. For tier 2, this means more roads, power plants, subways, etc.
But rather than pick a company that builds subways or coal-fired power plants or roads or nuclear power plants, at Global Gains we like companies that work across these niches. That's something like General Steel
China profit play No. 3: SSE-led consolidation
The fact is that while China's economy has been growing at a near-10% annual rate for the past 25 years, growth is slowing and the low-hanging fruit when it comes to spurring growth has long since been plucked from the tree. Thus, the government is focused on ways to make the economy ever more efficient. One of the strategies they've hit on is the forced consolidation of small, inefficient state-owned enterprises (SOEs) under private companies that they can count on to do right by workers and wring inefficiency out of operations.
We discovered some of these "chosen few" in the health-care and steel sectors during our last research trip to China, and we dubbed them SSEs, or state-sponsored entrepreneurs. We're keen to invest alongside them because of their good relations with the government and their advantaged position when it comes to acquiring new assets, products, or distribution capacity.
Take the next step
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This article was originally published June 30, 2009. It has been updated.
Tim Hanson is co-advisor of Motley Fool Global Gains. He owns shares of Yongye International. Novartis, General Steel, and China Green are Motley Fool Global Gains recommendations. Johnson & Johnson is an Income Investor pick. The Fool's disclosure policy is on the lookout for beef jerky profit plays.