How to avoid a China stock shock

July 5, 2011

Despite inflation worries, corporate accounting irregularities and drab stock market returns, China’s growth story continues to attract love from Wall Street.

More than 600 mutual funds and exchange-traded funds and nearly 300 companies listed on U.S. exchanges use “China” in their names, writes emerging markets investment specialist Carl Delfeld for Investment U, an investment advisory website. Many of the latter are China-based companies listed as American Depository Receipts.

But beneath the Chinamania is a laundry list of problems. While China’s GDP growth has galloped ahead of the rest of the world in recent years and is projected to continue doing so for the foreseeable future, most of its stock market indices have been considerably less buoyant. Over the last two years, a time when U.S. GDP growth trailed China’s by a wide margin, iShares FTSE/Xinua China 25 Index Fund rose 11 percent, compared to 43 percent for SPDR S&P 500.

Investors remain concerned on a number of fronts. At the top of the list: persistent inflation and the Chinese government’s efforts to control it. At the end of June, China’s consumer price index was poised to edge over six percent, something that hasn’t happened since 2008. That increases the likelihood of even tighter monetary restrictions for banks and higher interest rates in the months ahead as the government tries to rein in economic growth.

Opaque financial statements and accounting irregularities among public offerings conducted through a controversial technique called a “reverse merger” are the latest clouds hanging over a growing crop of small-company China stocks that have found their way to U.S. exchanges. Stocks of such companies, which merge with a publicly-traded shell company to gain back-door access to the U.S. markets,  have been under investigation by the SEC for alleged manipulation by short sellers.

None of this, of course, means that the China growth story isn’t real. But for most people, tapping into the long-term expansion of the region’s burgeoning consumer mindset and infrastructure needs through investments that cast a net beyond its shock-prone stock markets is a better bet.

Companies that satisfy the growing Chinese appetite for consumer goods appeal to David Winters, manager of the Wintergreen Fund, whose portfolio has stakes in Swiss watch and timepiece makers Swatch Group and Richemont, the company behind the Cartier brand. “These companies derive about one-third of their sales from the greater China market and are capitalizing on the region’s increasing demand for luxury items,” he says. “Their presence in the region has also helped offset weaker sales in other parts of the word.” They also have strong balance sheets and high levels of management ownership.

Many mutual funds have stakes in Brazil’s Vale, a large producer of iron ore, the key ingredient in steel, which has benefited from China’s building boom. Iron ore and copper producer Rio Tinto is another popular mutual fund bet on China’s infrastructure build-out. In the U.S., Louisville, Kentucky-based Yum! Brands, the parent company of KFC, Taco Bell and Pizza Hut, has a strong foothold in China and other emerging markets and is expected to draw 40 percent of its operating profits from its China segment this year, according to Morningstar analyst R. J. Hottovy.

With rising Chinese demand for commodities such as agricultural products and energy, exchange-traded notes — a close cousin of exchange-traded funds — also provide back-door access to the region’s economic growth. Although prices of individual commodities can be choppy, diversified offerings such as iPath Dow Jones-UBS Commodity and PowerShares DB Commodity smooth out the ride a bit by spreading their bets among a variety of commodities such as agricultural products, industrial and precious metals, and oil. And since they don’t always move in sync with most stocks, they are also a good way to diversify. For more specific commodity plays, Market Vectors Agribusiness follows securities involved in the agriculture business, or SPDR Select Materials focuses on industrial metals.

A small allocation of no more than around five percent of a portfolio toward an emerging market ETF or mutual fund is another way to have a foot in the China door. The largest emerging market ETF, the Vanguard MSCI Emerging Markets ETF, has an 18 percent allocation towards China but also branches into other emerging market countries such as Brazil, India, Russia, Korea and Taiwan.

It’s also a good idea to check under the hood of your portfolio for any existing stealth China exposure. If you own shares in an international or global mutual fund that invests in the region, a commodity ETF, or a lot of stocks in large multinational companies that do a good amount of business there, chances are you already have plenty of skin in the China game.

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