For the past two years, China's financial markets have mimicked the peaks and troughs of the country's Great Wall. But for the most part, it's been a successful trek to higher ground.
The Chinese market shot up 134 percent last year and, so far, is up 192 percent this year. Such high returns don't necessarily make the land of green tea and Confucius an obvious investment choice, however. "A lot of people say, 'The domestic stock market must be doing well because the Chinese economy is doing so great,'" says Winston Ma, author of Investing in China. But the reasons behind the stock market's boom are more complicated than that, he says, and many U.S. investors don't understand them.
Part of the mystery comes from the fact that Chinese citizens generally cannot invest outside their country, and foreign investment is also heavily regulated by the Chinese government. As a result, the domestic markets have been flooded with cash from Chinese investors with nowhere else to put it. That, not company earnings potential, largely explains the recent upswing. In fact, companies listed on both the Shanghai market and the New York Stock Exchange usually trade at a higher valuation on the Chinese exchange. Because a different set of investors has access to each market, there is no room for arbitrage.
So much cash in the market also means more volatility. Blaze Fabry, president of the Chinavestor research firm, estimates that U.S.-listed Chinese stocks are 2½ times as volatile on average as their American counterparts.
For aggressive U.S. investors who salivate at the thought of such a high-return, high-risk environment, U.S.-listed funds provide exposure to mainland China. The Morgan Stanley China A-Share Fund, for example, invests in companies listed on China's two exchanges in Shanghai and Shenzhen. Thomas Wilkins, chief executive manager at Joseph Jekyll Advisers in Athens, Ga., recommends it to more aggressive clients. (He purchased the closed-end fund for himself at $20 a share last October. Its shares are now worth $66.)
Safer. Most of the 28 China-focused funds traded in the United States, however, focus on Hong Kong and U.S.-listed securities, which tend to be cheaper and less volatile. PowerShares Golden Dragon Halter USX China Portfolio, an exchange-traded fund, is one example. John Southard, a managing director at PowerShares, says the fund provides exposure to mainland China but with added protection, because Chinese companies must meet certain accounting standards to be listed in U.S. markets. The fund, with $725 million in assets, is up 121 percent since it launched at the end of 2004.
Such steep growth makes some wary. "Recent gains are not sustainable over the long run," says Bill Rocco, a senior analyst at Morningstar. Single-country emerging-market funds tend to be overly narrow for the average investor, who should look for more diversity in his investments, he explains. Even for an aggressive investor who did want to buy a China fund, Rocco says, "two years into a furious rally isn't a good time to buy."
Plus, Rocco adds, many U.S. investors already have exposure to China's growth through multinational corporations or U.S. companies doing business in China, such as the construction and industrial equipment company Caterpillar. Many mutual funds, like Fidelity International Discovery, have small stakes in large Chinese companies. According to Morningstar, the fund has almost 1 percent of its assets invested in China.
Henry Chan, head of Asian equities at Baring Asset Management, isn't too worried about the so-called bubble bursting, like Internet stocks did at the beginning of the millennium. "We can still talk about earnings," he says, while a decade ago, tech investors began to use other measures, such as price-per-click, to evaluate money-losing online companies.
Value. Even where stocks are pricey—Jason Hsu, principal director for research and investment management at Research Affiliates, says U.S.-listed Chinese stocks trade at an overall P/E ratio of 60—those valuations represent high growth expectations for earnings. But, Hsu adds, the risk to investors is also high. Then again, says Dennis Stattman, a portfolio manager for BlackRock Global Allocation Fund, "you don't invest in China for safety. You invest in China for growth." And if you take the time to drill down into the Chinese market, it is still possible to find some relative value plays. Edmund Harriss, portfolio manager of the Guinness Atkinson China & Hong Kong Fund, points to bargains in industrial and materials stocks, such as China Shipping Container and Angang Steel. "It is still perfectly possible to construct a portfolio that is looking reasonably cheap," Harriss says. His fund trades at around 19 times estimated 2007 earnings.