Top Ways for Americans to Invest Safely

China is widely considered to be one of the most attractive and exciting long-term investment opportunities in the world. Last year, this nation of 1.3 billion people replaced Japan as the world’s second-largest economy and could surpass the US economy as soon as 2025. It already is the world’s largest exporter.

But after more than a decade of economic growth that averaged 9.9% per year and stock market returns that averaged 7.7%, there have been clouds in China’s investment outlook. Investors are asking whether China’s attempts to fight inflation by raising interest rates along with other measures will slow economic growth to a drastic degree. That could have bleak consequences not only for investments in China but also in other emerging markets and in diversified foreign-stock mutual funds.

Bottom Line/Personal asked emerging-markets investment expert Paul Goodwin why China is still a great place to invest despite the challenges it faces…

GROWING PAINS

From early November last year to late January, the Shanghai Composite Index plunged by more than 15%. It ended 2010 with an 11% loss for the year, compared with a 15% gain for the Standard & Poor’s 500 stock index.

Reason: Investor confidence was shaken as China faced rapidly rising inflation.

That inflation—a 5.4% gain in consumer prices for the 12 months ended in March—stemmed from factors such as a red-hot real estate market and the spiking cost of many commodities that China imports, such as oil, copper and iron ore. The central government raised its benchmark short-term interest rate four times in the last six months and will probably have to keep raising rates for months, which investors fear might crush economic growth.

These all are reasons for concern, but long-term investors shouldn’t panic. I think the government will be able to steer a path that avoids both runaway inflation and a plunge in economic growth. In fact, the Chinese stock market is up by about 8% this year as of mid-April despite additional pressures, such as soaring oil prices and much higher wheat prices due to a severe winter drought in China’s Northern Plains.

While there have been spectacular real estate price increases in such major cities as Beijing, Shanghai and Guangzhou, China isn’t facing a credit bubble like the one that devastated the US banking system in recent years. It avoided that kind of crisis by imposing strict mortgage lending requirements and strictly regulating the sale of derivatives—the packaged baskets of shaky mortgage loans that helped crush the US credit and real estate markets and that Warren Buffett dubbed “weapons of mass destruction.”

What’s really happening is that China is going through big growing pains as it struggles to decrease its tremendous reliance on selling exports to the rest of the world and increase its own domestic consumer spending. In the next few years, China’s economy is likely to grow by 7% to 10% a year—that’s still two to three times the rate that sluggish developed economies will likely achieve.

HOW TO INVEST

As an investor, it’s important that you have some exposure to China—which represents more than 10% of the world’s gross domestic product (GDP)—but you have to know how to invest there.

It’s difficult for foreigners to invest in China’s public companies directly because foreigners are required to have expensive, hard-to-obtain permits. Also, Chinese companies tend to have substandard accounting and financial disclosure practices. To avoid this problem, I choose investments only from among the 200 Chinese companies whose stocks trade as American Depositary Receipts (ADRs) in the US. These ADRs, which represent ownership in shares of foreign corporations that trade in US financial markets, are denominated in US dollars. They offer a measure of safety because the companies issuing the shares must meet stringent accounting, disclosure and financial statement standards approved by the Securities and Exchange Commission.

I also like US companies that have expanding operations in China.

Warning: Avoid the common mistake of investing in index funds and exchange-traded funds (ETFs) that track the broad Chinese stock market. That market can be very volatile, and I don’t want to risk losing 65% as the Shanghai Composite Index did in 2008.

My preferred approach is to focus on Chinese companies that are tapping into three trends so powerful that they are unlikely to be derailed by higher inflation or a slowdown in economic growth…

TREND 1: City living

China’s ongoing rural-to-urban shift is one of the largest human migrations in history. City populations will expand by 20 million this year. The stocks that benefit…

  • Freeport-McMoRan Copper & Gold Inc. (FCX) is the largest copper miner in the world. More and more Chinese city dwellers desire the amenities of modern life, such as TVs, air conditioners and appliances. The average home requires at least 90 pounds of copper in electrical wiring and appliances, so it’s not surprising that the worldwide price of copper has tripled since the early 2000s. Recent share price: $51.17.
  • Yum! Brands, Inc. (YUM) is one of the largest fast-food restaurant companies in the world, with about $11.3 billion in annual sales from franchised chains. That includes Pizza Hut, Taco Bell, Long John Silver’s and KFC—the dominant fast-food chain in China. Yum! has vast potential for growth in China, which has far more young consumers than the US. Recent share price: $51.12.
  • TREND 2: Trading up

    Along with moving to cities, millions of Chinese workers are earning higher wages, joining the middle class and exercising their new consumer spending power by buying homes, automobiles and computers and traveling more. The stocks that benefit…

  • Baidu (BIDU) is the leading Chinese-language Internet-search provider. Like Google, it collects its revenue through paid online advertising and has a virtual monopoly in its field. But Baidu has a much larger untapped market—only about 32% of the huge Chinese population already has access to the Internet, compared with 77% of Americans, and that will grow rapidly. Baidu also holds more than $1 billion in cash and has no debt. Recent share price: $146.81.
  • China Yuchai International Ltd. (CYD) makes diesel and natural gas engines for Chinese cars. In 2009, China overtook the US as the world’s largest car market, and in 2010, sales of vehicles in China jumped by 32%. This company will benefit greatly from China’s tightening of emission limits. Recent share price: $30.04.
  • TREND 3: Building boom

    The vast central and western regions of China still are largely underdeveloped. To balance out the vast improvements that have taken place in the big cities, China will make sure that these regions get trillions of dollars of basic infrastructure, including raw materials, power generation, roads, rail lines, airports, and water and waste systems. The stocks that benefit…

  • Caterpillar Inc. (CAT) is the dominant global manufacturer of heavy construction equipment, such as bulldozers and excavators, and engines for off-highway vehicles. China already is one of the largest markets for Caterpillar, with a total of more than $2 billion in sales there over the past five years. With 11 plants operating throughout China, Caterpillar is likely to be the leading construction equipment manufacturer there by 2015. Also, the need for major clearing and reconstruction following the earthquake disaster in Japan may require additional equipment from Caterpillar. Recent share price: $107.21.
  • CNOOC Ltd. (CEO) is one of China’s largest oil and natural gas companies. The Chinese now are the second-largest oil consumers behind the US and gaining rapidly. CNOOC’s exclusive rights from the government to partner with foreign companies in offshore production in places such as Indonesia, Nigeria and Australia give it a huge advantage over all Chinese competitors. Economic growth in China will be particularly lucrative for CNOOC’s natural gas business as the government looks for a cleaner fuel to meet burgeoning energy demands. Recent share price: $254.54.