Why It's Worth Investing in China

How would you have liked to earn 42.2% in a position over the past year? Given that less than 20% of all stocks achieved that level, and that the S&P 500 was up just 10%, odds are that 42.2% sounds good to you. But what if I told you that you had to invest in China to get it? Fewer investors would now be interested. Many people I've talked to find the country and emerging markets in general to be too volatile and risky to be worth their time.

At Motley Fool Global Gains, we believe that's a short-sighted approach, but we also recognize that China and other emerging markets are not without risk. In the case of China, that's a result of its immature economy, the amount the government can interfere in the economy, and the long track record of Chinese companies that have come up short when it comes to disclosure, transparency, corporate governance, and sustainable growth.

I believe, however, that there is a way to balance these facts and invest in China while limiting exposure to China's dark side -- and that's how we earned 42.2% over the past year.

Our China methodology
It was this time last year that Motley Fool Global Gains released a special report called The China Rural Boom Basket: 5 Ways to Play the Fastest-Growing Niche in China. Our thinking behind this report was to create one 5% position from five individual stocks that we researched during our trip to China last July that all stood to benefit from government efforts to raise rural incomes and increase domestic food production. Yet the reason we picked five stocks rather than just one to benefit from this trend is because of the aforementioned risks that come with investing in China. As a result, we believed that by spreading our exposure to this promising niche across a diverse group of companies large and small, multinationals and domestic Chinese names, and in different industries, we could earn considerable upside while limiting our volatility and downside exposure.

One year later, and it appears that we have achieved our goal. Our China Rural Boom basket is up 42.2% overall, which compares favorably to 9.9% earned by the S&P 500, the -6.4% returned by the Xinhua China 25 Index, and 14.2% earned by the excellent Matthews China mutual fund. How did we do it? Here's how our China Rural Boom Basket looked one year ago:

Source: Motley Fool Global Gains.

Yongye and China Green are two small fertilizer manufacturers in China (Yongye based in the north; China Green in the central part of the country) that were seeing sales of their green fertilizers rise rapidly as the government subsidized the purchase by small-scale farmers of more environmentally sensitive fertilizers. The stocks were cheap because they were (and still are) relatively new to the public market and considered unknown quantities by most investors. The same could also be said of China Marine Food, which at this time last year was just starting to expand sales of its seafood snack foods into central Sichuan province. And finally, we tried to ballast the portfolio with China Mobile and Coca-Cola, two huge blue chips that have developed unique sales and marketing strategies to reach rural Chinese consumers.

How the basket has changed
By November of last year, investors had caught on to the stories at Yongye and China Green, and both stocks had risen substantially -- Yongye more than 90%, and China Green more than 100%. Rather than allow the portfolio to be weighted toward these still small, unproven names, we opted to rebalance our exposure back to the other three companies, which had not risen nearly as quickly. That's turned out to be a good move because while Coca-Cola and China Mobile have subsequently held their value and paid nice 3% dividends to investors, China Green shares have dropped back down to $10 or so. That's a great example of the potential for volatility when it comes to investing in China and a good reason to invest in promising themes in the country using baskets of stocks.

We also elected to sell our exposure to China Marine Food at $4.22 this past June and roll the proceeds into Coca-Cola, citing our inability to confirm sales guidance for the company's new algae drink, Hi-Power. In fact, when we first bought the shares last year, we had no idea China Marine was going to get into the drink business at all. Questions raised by investors in the wake of that acquisition and our inability to confirm certain points of sale convinced us that our exposure was better off in Coca-Cola. While the volatility that's accompanied this ongoing saga has been severe, with China Marine shares dropping from $5.50 to below $4 and now back to $4.50, the fact is that the basket helped insulate us against this wild ride. That's exactly how the basket approach is supposed to work -- enabling us the luxury of time when questions do arise with one of the companies.

The basket going forward
Given those changes, here's how our China Rural Boom Basket looks today:

Source: Motley Fool Global Gains.

Our goal with this basket is maintain diversified exposure to a still promising theme in China: government efforts to raise rural incomes and increase domestic food production. These remain priorities for the Chinese government today, and we expect many more good years from our China Rural Boom Basket.

Going forward we hope to identify and vet a candidate to replace China Marine to get the basket back to five stocks since diversification is a key aspect of the basket approach. We may also rebalance to increase our exposure to China Green back closer to 1% given that it is now underrepresented relative to its intended waiting. Before that happens, however, we may wait to see the company's full report for fiscal 2010 (which ended June 30) and see if it makes progress on its promised auditor upgrade.

In the meantime, we've recently returned from another research trip to China and are working to construct a basket to give us exposure to another promising theme: The rise of the Chinese consumer. We expect to have that report ready by Monday, and you can sign up below with your email address to receive information on how to get it.

But even if you don't want our report, I encourage you to add exposure to China and other fast-growing emerging markets to your portfolio via targeted baskets that include a variety of companies -- large and small, domestic and multinational, several different industries -- as in the example above. Not only will this strategy help you increase your foreign exposure -- something most U.S. investors lack -- but it should help insulate you from the wild swings that emerging markets stocks can offer on their own.

Get Tim Hanson's Global View column every Thursday on Fool.com, or by following him on Twitter.