Investing In China 2012

China is the hottest business and investment story on the planet. The 21st century has already been proclaimed the "Chinese century," and shock waves from China's frenzied entrepreneurialism, manufacturing prowess and low-cost labour are rocking industries throughout the world. As in every gold rush, fortunes are being made, and each new tale of a freshly minted zillionaire fuels the China fever. China is the biggest growth story in history. We can't afford to miss it! Well, we aren't going to miss it, because, like other economic tidal waves (the Internet, for example),

China will affect us whether we invest in the country or not. And before we rush in, we should remember that the Internet craze melted down not so long ago, and one other megatrend, real estate, may yet do the same. But we wouldn't be human if we didn't dream, and China's size and three decades of spectacular wealth creation certainly offer much in the way of inspiration. So how can we cash in?

The safest but most labour-intensive China investment strategy is to move to the country, learn the language(s) and settle in for a decade or two. This way, you can be close to the action, and if you don't strike it rich on your own you can sell your China expertise to someone else. If you're not up for this level of commitment you can buy China-related securities, either directly or through funds.

If you go this last route, of course, sometimes what you will be buying is not the actual stock of a Chinese company, but the stock of, say, a Cayman Islands company that has a contractual relationship with a Chinese company, one that you must pray will last longer than many contractual relationships in China (where contracts are often viewed as a snapshot of an ever-evolving arrangement). The same Chinese companies also occasionally list stock simultaneously in Shanghai, Hong Kong and New York, and trade at different prices on each market—so you might end up paying more for the same asset than a professional investor with global reach.

Which brings up a key point, one that is often lost in the din of do-it-yourself investing propaganda: you can buy China stocks, —if you really want to, but there is absolutely no reason for you to do so. On the contrary, there are dozens of reasons for you not to do so, starting with the competition.

Professional China investors live in China, speak Chinese, visit Chinese companies, drink baijiu with Chinese managers, schmooze with Chinese lawmakers and party members and have dozens of China-focused Wall Street analysts calling them day and night with every crumb of China-related information they find. These investors have multimillion-dollar research budgets, deep China expertise and armies of Chinese analysts, and many were born and raised in the country (before being educated at Harvard et al.). Once in a while we may uncover some gem that these experts miss, but chances are slim that we can do it consistently.

So if buying individual China stocks sounds nerve-racking, you can (wisely) opt for a mutual fund. But here, too, beware. Even dime-a-dozen U.S. funds often charge egregious fees, and fees on foreign ones can be especially steep (2 percent of assets per year, or more). Also, although many China funds have posted excellent performance over the past few years, this performance may have been the result of market trends or luck (the H shares, for example, have had a strong three years).

It may be true, as some argue, that China's markets are so inefficient that most managers can deliver above-market performance (contrary to the case in the United States, where they can't), but the jury is still out on this. In any event, you're probably best off seeking low-cost active funds, passive index funds or exchange-traded funds (ETFs).

In Hong Kong and New York, on the other hand, China stocks may actually be cheap. Merrill Lynch, for example, estimates that the Hong Kong H shares are trading at about 11 times 2005 estimated earnings, versus a long-term U.S. average of about 16 times earnings, and this valuation appears attractive for long-term investors. Whether this is the result of the market's anticipating an economic slowdown or simply an appropriate discount to compensate for China's risks and uncertainties, is unclear, but at least the stocks don't appear to be incorporating much of a China premium.

But this still doesn't mean that it makes sense to buy them. Despite the attractiveness of China's long-term story—presumed future economic superpower and so on—its stocks are still just a subset of a minor asset class: emerging-market equities. As such they should constitute, at most, only a tiny fraction of the average portfolio.

China, moreover, is only one of dozens of emerging markets—it currently represents only 7 percent of the MSCI Emerging Markets Index, for example—so the total China exposure should usually be far less than 1 percent of assets. Most investors can get all the China exposure they need by owning U.S. companies that do business there or small helpings of Asian and emerging-markets funds.