The Next Great Place to Invest

There I was, eating breakfast, looking out over downtown Hohhot, sipping Mongolian milk tea, and flipping through the China Daily. I was wondering whether it was worth it -- traveling more than 7,000 miles from Washington, D.C., to Inner Mongolia in search of the next big stock idea -- when I came across an article that made me believe it was.

But before I get to the contents of that article, I want to address something from The Wall Street Journal this past weekend about which I've received a number of emails. Professor Elroy Dimson of the London Business School now argues that "the economies with the highest growth produce the lowest stock returns -- by an immense margin."

This makes no sense
According to Dimson's study, stocks in the countries that have produced the most dramatic economic growth over the past decade -- think China, India, Brazil, and the like -- have on average delivered just 6% returns to investors. That's compared to 12% returns in the world's slower-growing, developed nations.

The reason for this, of course, is valuation. Tech stocks such as Wave Systems (NASDAQ:WAVX), Red Hat (NYSE:RHT), Ariba (NASDAQ:ARBA), and RealNetworks (NASDAQ:RNWK) have produced negative returns since 1999, despite growing their revenues at more than 10% annually over that time, because investors bid their stock prices up too high. Same goes for stocks in emerging markets.

Investors see the eye-popping development taking place in China and Brazil -- and, yes, that development is real -- but they end up paying far too much to get a piece of it in their portfolios.

In other words, there's a valuation trap when it comes to investing in high-growth emerging markets. To capture their growth, you need to be willing to buy into them when their valuations plummet, which is usually when some kind of economic crisis strikes.

Did you say "economic crisis?"
In fact, we just experienced one of those times. Chinese stock valuations were absolutely crushed from October 2008 through as recently as May 2009, as freaked-out investors pulled their money out of any and all stocks they perceived as "risky."

We at Motley Fool Global Gains, an investment research service I co-advise, took advantage of that opportunity to pounce, recommending China Green Agriculture, American Oriental Bioengineering, and China Marine Food Group in rapid succession. As you can see, the returns thus far from the group have been worth the temporary discomfort of acting contrary to the conventional wisdom (though we did recently sell AOB, after becoming uncomfortable with some of the management team's decisions):

*Until sale.

Of course, returns of that magnitude mean that money is flocking back to emerging markets, causing valuations to rise. That, in turn, means that the window to earn outsized returns in emerging markets is closing.

But there are still windows of opportunity
This brings me back to that article I read in the China Daily newspaper over milk tea in Inner Mongolia on my recent research trip to China.

According to that article, there are two economic realities in China. The first is the reality of coastal China, the part of China everybody knows about. This is the China of Beijing, Shanghai, and Shenzhen -- the massive cities that have led China's rapid economic growth for the past 25 years.

The other China, however, is western China; the China of relatively unknown provinces such as Inner Mongolia, Shaanxi, and Xinjiang. These are the poorest parts of the country -- regions that have been largely left behind by China's economic development.

The headline for prospective investors in China, however, is that this is starting to change.

Thanks to massive government spending to raise rural incomes and even out infrastructure development across China, western China is now the country's fastest-growing area. In fact, that part of the country is growing at more than 11% annually, versus just less than 9% for the rest of the country. And Inner Mongolia, the province I was sitting in wondering whether the trip was worth it, has been the fastest-growing province of all, posting incredible 16% annual GDP growth from 1998 to 2008.

Why this matters
I bring this up because unlike high-profile Beijing- or Shanghai-based companies such as China Finance Online (NASDAQ:JRJC) or E-House (NYSE:EJ), companies in western China remain relatively unknown to outside investors. What's more, this relative anonymity is reflected in their valuations.

According to my research, companies in the developed parts of China currently trade for 60 times earnings. Companies in rural China, however, trade for less than 11 times earnings.

Put another way, the companies in the fastest-growing parts of China are today also the cheapest -- exactly the opposite of what we would expect, given the Dimson research I mentioned above.

This is why we see enormous opportunity in investing in rural China today, and why I now consider my trip to Inner Mongolia to have been more than worth it. In fact, Inner Mongolia is home to my top stock pick from the recent trip.

Want to know more?
To learn all about that top company, and read our entire special report on the five stocks to buy today to play China's rural boom, simply click here to join Motley Fool Global Gains free for 30 days. The sooner, the better, too. As I said before, the emerging-market investment window is closing, and the market will eventually catch on to the opportunities it's missing in rural China.

Of course, you want to buy in before that happens.

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This article was first published on July 30, 2009. It has been updated.

Tim Hanson is co-advisor of Motley Fool Global Gains, and only just this week finally got over his jet lag. He owns shares of American Oriental Bioengineering and China Marine Food. AOB is a Motley Fool Hidden Gems selection. China Green and China Marine are all Global Gains recommendations. We tell you this because of the Fool's disclosure policy