Last week was tough for China bulls, as two longtime worries have many investors avoiding the country, at least for one day anyway. Investors became worried about inflation in China as the country's consumer price index showed a 4.4% increase over the same period last year. An overheated economy could lead to slowing actions such as interest rate hikes by the People's Bank of China. China's Shanghai Index dropped more than 5% on Friday -- the largest decline in more than a year -- in anticipation of action by the PBOC.
However, I don't recommend investors take their economic cues from the daily movements in China's stock market, which is still more like a casino then a proper functioning capital market. Albert Keidel, former deputy director of the U.S. Treasury's East Asia office, says, "Chinese stock market clients used the markets more as a gambling mechanism or get-rich-quick vehicle, since those with privileged access to underpriced initial offerings frequently saw the prices of their assets jump considerably on the first day of trading. China's stock markets thus still cannot and are not taken seriously as well-functioning financial institutions."
While investors need to beware of this get-rich-quick mentality, there are still some good investment opportunities in China.
On a more micro level, RINO International
These issues highlight one reason that many are bearish on China, including famed short-seller Jim Chanos. The rapid increase in small Chinese companies listing shares in the U.S. through reverse mergers with shell companies is one thing. Chanos believes there is also a fair bit of "financial engineering" even among more established Chinese companies. He finds it interesting that the large profits Chinese companies are reporting almost never seem to show up in actual cash.
Where to invest in China
I don't believe this means China should be off-limits for investors. There are many reputable China-based companies listed on America exchanges. It just means researching the business practices of these companies is even more important.
Many of the U.S.-listed companies that have come to market through reverse mergers have hired BDO Limited's Hong Kong office to audit their books. However, investors need to go a step further when investigating Chinese companies. BDO audits the books of companies such as Gulf Resources
A China winner
In particular, I prefer KPMG-audited organic fertilizer maker Yongye International
Yongye is also set to see a giant boost to its earnings through smart vertical integration. The company recently purchased a lignite coal mine in order to take control of the most expensive input in its business operations. Crops and nutrients derived from the coal make up close to 50% of Yongye's costs. Now instead of paying large mark-ups to suppliers, they can instead pay themselves, and maintain a much more reliable production schedule.
Yongye is just one of many ways to play China's booming economy. Investors should not be scared away by the indiscretions of some, as this just increases the opportunity to find companies like Yongye at compelling valuations. Sure it increases your homework, but it also increases the possible reward.
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Andrew Bond owns no shares in the companies listed. Yongye is a Motley Fool Global Gains selection. The Fool owns shares of Yongye. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.