Famously Volatile, Richly Rewarding
China Beckons -- if You Can Stomach the Swings

By Tomoeh Murakami Tse and Ariana Eunjung Cha
Washington Post Staff Writers
Sunday, July 22, 2007

NEW YORK

It's the money tree that keeps on giving.

Despite warnings about the lack of transparency, corruption scandals and companies with shaky financials, the Chinese stock market has leaped 300 percent in the past two years.

No other major market in the world has rewarded investors as generously. Consider: Brazil, Russia and India -- the other fast-growing countries that make up the so-called BRIC economies -- gained at most 170 percent over the same period. The Standard & Poor's 500-stock index rose 24 percent.

But like other emerging economies, China's poses some serious risks for investors. Its stock market is notoriously volatile. A series of one-day plunges have left the benchmark Shanghai composite index about 7 percent below its highs in May.

Concerned about speculation, the Chinese government is trying to temper the red-hot market. It is also trying to slow the rapid pace of economic growth, which could further cool the market. At the same time, Beijing is battling to limit fallout from tainted Chinese products sold in the United States.

A growing chorus of observers -- including U.S. analysts, Chinese officials and former Federal Reserve chairman Alan Greenspan -- are voicing concern that China's stock market is a bubble ready to pop. All this, while Wall Street is stepping up its offerings of China-focused investment products and as Chinese companies are going public on U.S. markets at a record pace.

So is it time to ease away from Chinese shares? Or has the great rise only just begun?

"There's a point where you have to revalue markets and stocks that have done so well so rapidly," said Kirk Brown, who oversees investing in foreign markets at American Beacon Advisors. While Brown doesn't expect Chinese stocks to fall sharply, he said they could be headed into a period "where they kind of languish for a number of quarters until earnings catch up to their stock prices. . . . I would think people would want to be more cautious in putting more money to work in China at this point."

Nonetheless, he and other money managers see reason to have exposure to China in the long run. They say the country's 1.3 billion people represent a consumer base whose potential has barely been tapped. The Chinese economy, projected to grow in the double-digits for the fifth straight year, is threatening to overtake Germany as the third-largest economy in the world.

"I think it ought to be clearer and clearer to people all the time that China's advance is real and that they probably would benefit to have some exposure to China," said Donald H. Straszheim, vice chairman at Roth Capital Partners and former chief economist at Merrill Lynch.

Investors should be aware, however, that it can be difficult to get trustworthy information about companies in China. Disclosure rules aren't up to global standards. Although the economy is opening up, it is still run by a communist government struggling to foster a free market. Many companies are state-owned.

"You kind of have information where you largely have to trust the Chinese government as your partner [and] that this information is accurate and reflects the reality of what has happened at the company," said Michael Breen, senior analyst at Morningstar.

Two qualities best protect investors in China: a long-term outlook and skin thick enough to ride out the bumps, money managers said.

Investors who aren't Chinese citizens can't invest directly in China's so-called A-shares. Companies listed on the A-shares market are incorporated in mainland China and trade in renminbi, the official local currency. It's these shares that have given the market its breathtaking gains and dizzying drops. Many analysts say these shares have been driven up by speculative and inexperienced domestic retail investors, who are restricted from investing overseas.

In late February, a plunge of nearly 9 percent in the Shanghai index was blamed for triggering a global equities sell-off. The index recovered to hit all-time highs just a month later. But then the bumps came again, with a 6 percent drop in late May followed by an 8.3 percent decline the following week.

Foreigners do have access to the much smaller market in B-shares, which trade in dollars on the Chinese exchanges, and H-shares, which are stocks of companies incorporated in mainland China but listed in Hong Kong.

For individual investors in the United States, the easiest and perhaps safest way to play China is through a China-focused mutual fund. Wall Street has been rolling out more of them in recent years, and there are more than a dozen to choose from. These funds often own little or no A-shares and are comprised of H-share and B-share holdings as well as shares of Chinese companies listed in the U.S. exchanges.

For the first six months of the year, China funds gained an average of 25 percent, compared with less than 9 percent for U.S. diversified equity funds, according to data firm Lipper. Funds that focus on various emerging markets returned about 17 percent.

Because of the Hong Kong exchange's stricter requirements, H-shares are generally regarded as higher-quality. And in general, market swings have been easier for H-share investors to stomach. When Shanghai A-shares fell 8.8 percent Feb. 27, H-shares dropped 3.1 percent.

The Hong Kong-based shares have registered robust gains, though not as impressive as those on the mainland. The benchmark H-shares index has gained 24 percent this year, compared with 49 percent for Shanghai A-shares.

Money managers have varied opinions on H-shares' vulnerability to fallout from the mainland market. But one thing is certain: A-shares, which trade at about 40 times earnings, compared with 20 times for H-shares, have a longer way to fall.

Richard Gao, portfolio manager of the Matthews China Fund, said he would be concerned about a downturn in the A-share market if it were caused by weakening economic fundamentals. He would be less worried by a retreat of speculative money. The Matthews fund invests in H-shares but does not own A-shares.

For now, Gao is not too worried. "The overall macro-economy has been growing very fast. Corporate earnings have been strong," he said.

U.S. investors also can invest in a growing number of Chinese companies listed on the stock exchanges in New York. Some are traded through a security known as an American Depositary Receipt, or ADR. ADRs, like stocks, must meet U.S. listing requirements, including regular filings with the Securities and Exchange Commission.

Today, 45 Chinese companies are represented on the Nasdaq Stock Market, up from 34 at the end of last year and 16 in 2004. The New York Stock Exchange has 26 Chinese listings.

Another way to play China is through large, multinational companies that do big business there. Many companies have been using China as a cheap manufacturing base for exports. But some have started looking inward to China's domestic market.

With a savings rate higher than practically anywhere else, China's consumers have cash to burn. Over the past year, the U.S. government has been pushing Beijing to encourage Chinese consumers to buy American. Any increase in Chinese sales could help the stocks of the U.S. suppliers.

But capturing the Chinese market can prove tricky. Chinese consumers' tastes are not necessarily the same as Americans'. Shirts and dresses with bows and ruffles are all the rage among grown Chinese women. Chicken feet remains a popular dish (the United States already sends a lot of its leftover chicken feet to China). And tasteful home decorating among the Chinese nouveau riche can mean in-house fountains glowing with neon lights.

The Chinese government is the biggest consumer of all, so suppliers of raw materials used to build up the country could grow, said Gao Shanwen, chief economist at Anxin Securities in Shenzhen. Companies in the concrete, steel and timber business stand to benefit.

Another growth area is in energy and the environment. The government is making a major push to clean polluted air and water and is looking for cleaner sources of energy.

Analysts say investors should be cautious about mature industries such as consumer electronics. For instance, you can already get a new computer in China for about $300. "Personally, I think investing in televisions or in the mobile area is not that safe," said Ji Shupeng, a researcher at Hollyhigh Investment Consulting.

Cha reported from Shanghai.