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Is it Time to Bet on China?

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors have been very concerned about the economic slowdown in China for several months. The Chinese economy is decelerating from the record growth rates observed in previous years, and the country has a very peculiar economic system that generates considerable noise and uncertainty. Over the last weeks, however, many economic indicators are pointing to a successful soft landing for the Chinese economy and, if this trend is confirmed, Chinese stocks could be about to deliver some strong gains in the middle term.

The Giant is Waking Up

For the first three quarters of 2012 Chinese GDP has risen by a 7.7%, which means that the economy is on track to meet the government's target of 7.5% for the year. Recently released economic data confirmed the positive outlook by surpassing analysts’ predictions: industrial production in September grew at a better than expected 9.2%. Retail sales were even better, rising by a much stronger than expected 14.2%, which signals a strong rebound in consumer spending.

Business owners have been growing more optimistic, according to the MNI China Business Sentiment, a private sector survey of businesses in 32 cities. The survey showed an improvement in its reading for October, rising to 51.52 from 51.35 in September. The economic cycle is a dynamic process, so things could turn for the worse again, but the fact is that economic statistics in China have been surprising to the upside lately.  

The best part is that investors have feared a hard landing in China for a long time, and many China-related stocks are trading at historically attractive valuations. A stabilizing Chinese economy could dissipate investors’ fears about the cyclical scenario in the middle term, so it could be the catalyst for huge gains in China-related assets over the following months.

The Benefits of Diversification

Chinese stocks can be quite risky; government intervention in is always a factor to watch closely, and there have been several cases of medium and small sized Chinese corporations which were involved in financial fraud. For this reason, diversification may be a smart way to control risks when it comes to investing in China.

The most popular ETF to invest in China is the iShares FTSE/Xinhua China 25 Index : FXI), which holds a basket of 25 big cap Chinese companies. Stocks in its portfolio are trading at an average P/E of 8.25 on a forward basis and yielding a 2.5% in dividends, which means a compelling valuation by historical standards for Chinese companies.

Unfortunately, this ETF is not the best alternative when looking at its holdings: it has only 25 positions, and financials represent more than 50% of the portfolio; this too much concentration in the financial sector, which is not very transparent.

The lesser-known Guggenheim China Small Cap : HAO), may actually be a better investment than its more popular alternative. This ETF invests in mid- and small-cap Chinese companies, holds more than 200 securities, and the biggest position is no larger than 1.45% of the portfolio, so it provides a much higher degree of diversification.

Smaller companies have less exposure to heavily regulated sectors like Energy, Telecom and Banking, and they are also a more direct way to bet on rise of the Chinese consumer.  HAO holds more than 25.5% of its assets in the industrial sector, consumer (19.3%) and basic materials (15%) are heavily represented, but 12% of the portfolio is focused on the unstable real estate sector. This ETF pays a 3.1% dividend yield.

To Shanghai via New York

China Mobile ) is the leading telecom company in China, with an estimated market share above 66% and more than 670 million subscribers. The telecom sector in China is plagued with regulatory complications, but China Mobile is offering a dominant position in a high growth market, and an attractive valuation with a P/E ratio of 11 and a dividend yield of 3.5%.

The company´s competitors, China Unicom and China Telecom, already have licensing agreements with Apple ), while China Mobile is still in negotiations with the Cupertino company to include the iPhone 5 in its network. The negotiations are reportedly getting complicated over subsidies issues, but both companies have a lot to gain from a deal, so it does make sense to assume they will reach an agreement sooner or later.

The Apple brand is very popular in China; during the quarter ended in June 2012 iPhone sales in mainland China were up 100%  from the same quarter in the previous year, and that´s without including the biggest carrier in the country. If China Mobile finally reaches an agreement with Apple, it could become a very convenient way to benefit from the power of the Apple brand in a very under-penetrated market.

Yum! Brands (NYSE: YUM) is not a Chinese company, but it makes nearly 40% of its operating earnings from that country.  The owner of KFC, Pizza Hut and Taco Bell has been more successful than its competitors when it comes to positioning itself for growth in China, and the company´s management recently upgraded its plans to increase the number restaurant openings in China this year to 750 locations, up from previous expectations of 700.

The Chinese middle class will continue expanding rapidly over the following years, and that bodes well for fast food demand. Yum! is not particularly undervalued, at a P/E ratio of 21 and a dividend yield of 1.9%, but the company provides an excellent vehicle to bet on Chinese growth via a well-known US company.

Bottom Line

Investing in China can be risky, and investors should brace themselves for high volatility in the country. But it also represents a huge opportunity to invest in one of the most exciting economic growth stories of our time. Now that the economy is showing signs of stabilization, it may be a good time to consider investing in this re-emerging superpower.

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acardenal owns shares of Apple. The Motley Fool owns shares of Apple and China Mobile. Motley Fool newsletter services recommend Apple and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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