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China's stocks deserve a second look

Read David Berman's Market Blog at

Just about everyone celebrates China as an economic miracle and a leader in global growth, but they shun the country's stocks. It might be time to rethink this contradictory approach.

Many investors like to point to the country's trifecta of short-term problems - rampant corporate fraud, high inflation, and a possible real-estate bubble - as key reasons for staying out of the market.

They've had no regrets: As global stocks have rallied over the past two years, China's benchmark index has gone nowhere. And it has tumbled more than 50 per cent from its peak in 2007.

But longer-term investors should take a second look. The country's problems are either fixable or hardly deal-breakers, and the potential upside could make a bet on stocks pay off handsomely down the road.

Even a slowing in Chinese economic growth dazzles. The International Monetary Fund estimates that the economy will grow 9.5 per cent next year, down only slightly from 10.3-per-cent growth in 2010 and more than double the expected growth for the global economy.

At the same time, Chinese authorities are working to bring down the inflation rate by tightening monetary policy and restricting bank lending, moves that should throw a wet blanket on real estate speculation.

In other words, it's reasonable to expect China's economic growth to continue to lead the world - so why won't its companies thrive?

Valuations are no obstacle. The Shanghai stock exchange composite index trades at only 15.4 times trailing earnings. That's the lowest valuation going back at least 14 years, and offers a compelling reason to make a direct investment in China rather than through multinationals that are expanding into the region.

Fraud remains a concern, of course, and a blogger's report this week revealing a remarkably sophisticated fake Apple store in China underlines the country's credibility issues.

But most retail investors should probably restrict themselves to either mutual funds or exchange traded funds anyway, where a large basket of holdings will offer some protection from the occasional blow-up.

The SPDR S&P China ETF is a good place to start. This is a popular ETF that trades in New York and provides exposure to 152 Chinese companies, including big names such as China Mobile Ltd., Baidu Inc., CNOOC Ltd. and PetroChina Co. The price-to-earnings ratio is only 11.7, based on estimated earnings.

Investors who prefer ETFs that trade in Toronto have a good selection. The iShares China Index ETF tracks 25 stocks, with a heavy exposure to financials. There is also the Claymore China ETF and the BMO China Equity Hedged fund, which provides returns in Canadian dollars.

The SPDR fund hasn't done much, returning 2.6 per cent this year after factoring in dividends, and the iShares fund has fallen 4.7 per cent.

But that's part of the attraction: With expectations on China so low, the big gains are ahead.

© 2007 The Globe and Mail. All rights reserved.

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