Early in the second half of 2009, I warned investors to stay away from Chinese IPOs. New issues were at a standstill in developed markets, and Chinese authorities had ended a 10-month ban for new listings on domestic exchanges the previous month. This opened the floodgates to a wave of pent-up investor demand, producing inflated valuations. Rather predictably, these stocks have not performed well since then. Today, however, opportunistic, value-driven investors may be able to spin the losses of those who wanted to be first to the party into gains.

2008-2009: A very disappointing vintage
I looked at the performance of Chinese stocks that listed in the 12-month period leading up to the publication of my article (with a floor on company market capitalization of $250 million). The following table summarizes the results:

 

Equal-Weight Annualized Return, Aug. 1, 2009 to Jan. 24, 2010

Market-Cap Weighted Annualized Return, Aug. 1, 2009 to Jan. 24, 2010

Chinese IPOs, All Bourses (25) 8.4% (13.5%)
Of which: IPOs on U.S. Bourses (3) (23.6%) (18%)
Benchmarks
MSCI Broad China ex-HK Index* -- (2.6%)
iShares FTSE/ Xinhua China 25 Index (NYSE: FXI) -- 1.9%
Vanguard Emerging Markets ETF (NYSE: VWO) -- 22.1%
S&P 500* -- 19.8%

Source: Author's calculations based on data from Capital IQ, a division of Standard & Poor's, and MSCI. *Price return, in U.S. dollars.

The numbers are telling: Returns on these IPOs have been pretty awful -- particularly for the three companies that listed on U.S. exchanges: Duoyuan Global Water (NYSE: DGW) (-46.4%), Chemspec International (NYSE: CPC) (-14.6%) and Changyou.com (Nasdaq: CYOU) (-9.6%) (keep in mind, too, that these figures are annualized.)

From repellent to mouthwatering
In some cases, however, these haircuts have turned stocks that were previously unpalatable into much more appetizing propositions. In fact, Duoyuan Global Water and Chemspec are two of the stocks in a basket trade idea I've put together:

 

Industry

Premium (discount) to First Day Closing Price*

Forward P/E* (NTM earnings)

Charm Communications Advertising 8% 8.6
Chemspec International Specialty chemicals (16%) 8.3
China Real Estate Information (Nasdaq: CRIC) Real estate services (42%) 15.4
Duoyuan Global Water Industrial machinery (46%) 7.6
Lihua International (Nasdaq: LIWA) Electrical components and equipment 95% 6.5
Basket, Equal Weighted     9.3
Basket, Float-Adjusted Market Cap-Weighted     9.3

Source: Capital IQ, a division of Standard & Poor's, Yahoo! Finance, and author's calculations. *At Jan. 25.

If you're wondering how I came up with this basket, it's the product of a somewhat arbitrary selection process. I started with 36 U.S. market listings of Chinese companies that took place over the past two and a half years, looking at the sectors in which the companies operate, their profitability, and, most importantly, their valuations. Note that all five components carry zero or near-zero debt on their balance sheets. In addition, the basket has achieved an impressive average weighted return on equity over the past four years of 26%.

Don't underestimate the risks
Let me be very clear with my "return policy": One, I'm not making individual recommendations, this is a basket trade (i.e., it's all or none). Individual stock selection would require in-depth research on these businesses, which I haven't done. Second, the basket trade itself isn't a recommendation; it's an idea -- as always, stock investors must do their own due diligence. Third, investing in Chinese small-cap companies is inherently a speculative endeavor for any number of reasons.

Nevertheless, if you still feel it is absolutely necessary to own small-cap Chinese companies with a limited history as publicly traded entities, this is a smarter way to do it than simply going out half-cocked and buying shares in the first issue that comes to market.

Chinese IPOs: Two competing trends
For investors who are interested in this type of speculation, but want to become more familiar with this segment, there is absolutely no hurry. I expect the "boom-bust" phenomenon I have described in this article to occur periodically over the next decade, as two competing trends trade influence on share prices: Western investors' obsession with getting a piece of the China growth story and Chinese companies' increasing equity issuance to foreign investors.

There is surely no need to document the first of these trends, but the second one is perhaps less obvious. As financial economist Andrew Smithers of Smithers & Co. pointed out to me last September:

The expected real return on corporate equity investments in China should be the same as that elsewhere, measured in a common currency and thus lower in domestic terms to allow for China's rising real exchange rate (the Balassa-Samuelson effect). This is rather like Japan in the 1950s and 1960s. ... The equilibrium position would then be for China to import lots of equity money from the rest of the world.

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Alex Dumortier, CFA, has no beneficial interest in any of the companies mentioned in this article. You can follow him on Twitter. The Fool owns shares of Vanguard Emerging Markets Stock ETF. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.