Investing in China with Cautions

Because of my connection with China, I always keep an eye on what’s happening 6000 miles away from my house. These days, the biggest story in China seems to be that its once relentless climbing stock markets finally hit the break. Since closed at record high on May 29th, the Shanghai Stock Exchange Composite Index (^SSEC) lost nearly 20% of its value in a matter of a week. Despite the sharp decline, the index, however, is still up more 27% in 2007 and in the past year, the SSEC index has more than doubled. Following is a chart (click to enlarge) that compares one-year performance of SSEC (red), S&P 500 (blue), and two China ETFs, PowerShares Golden Dragon Halter USX China ETF (PGJ, green) and iShare FTSE/Xinhua China ETF (FXI, orange).

I have been investing in China since 2002 and, lucky enough, have had some success by starting early. Now my China investments include LFC, GRRF, XFML, TSM, and PGJ. Given the country’s potential, I will continue to hold my China related shares and probably will add some more, but I will be more cautious. In fact, there are several articles recently urge investors to be more careful when considering investing in China. For example, early last month, an article on Morningstar.com reminds investors that despite the growing self-governance at Chinese companies,

the government remains heavily involved in the operations of many Chinese companies as well as in the running of the overall economy, so these funds are quite exposed to political and governmental risks.

An article on the Wall Street Journal over the weekend, titled ‘Bubble’ Alert: Be Wary of China Stocks, says that the recent rally has made many “China stocks extremely expensive relative to their earnings, ” with the average P/E ratio of stocks in the SSEC index at 50 as compared to 18 of companies in the S&P 500 index. And from my own experience, things can easily get emotional in China. People can buy things at the same time, and they can sell things at the time as well just because everybody else is selling. With about 30 years of history, both the stock markets and investors, especially small investors, in China are far from mature. Fortunately, US investors don’t have directly access to the Chinese stock markets and, thus, they don’t directly participate in the hypes.

With all the risks and valuation concerns of China stocks and speculations that the bubble may burst, what investors could do to protect themselves from getting burned?

The Morningstar article says that most investors

would be better off with a diversified or regional emerging-markets vehicle that pays significant attention to the Middle Kingdom. And while it is certainly true that China funds can be productive holdings for sophisticated investors who already have well-diversified portfolios of international funds and want some extra pop, even such individuals need to be careful with these funds.

That advice is echoed in another Wall Street Journal article yesterday, which argues that

one of the safest routes for U.S. investors is to invest in a China-focused mutual fund. Fund managers can help mitigate exposure to risky stocks and will be able to pull out of the market if it goes belly up.

And this can be seen from the above plot. Both PGJ and FXI invest in Chinese companies listed either on Hong Kong or US stocks exchanges (ADR). The gains of these two funds are rather moderate compared to the SSEC index.