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Avoiding China's Risks

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

China is a great story. As this nation industrializes and more of its massive population moves toward middle-class status, there is definitely a lot of money to be made. However, China isn't the United States and there are some big risks to keep in the back of your mind. Here are a few stocks that might be best avoided, and a couple to strongly consider.

The Upside
The true story in China is about industrialization. There are lots and lots of people in China that live in less than desirable circumstances. That said, the country is moving from a largely agrarian economy to an industrialized one. The same shift took place in the United States and other industrialized nations around the world.

There is no question of the benefits of such a shift. The China story is really huge, perhaps bigger than the U.S. story. So long as the country continues its steady march toward developed status, things are going to be fine. That transition should last a long time yet. So why worry?

A Risky Country
Demographics could be a long-term issue, as the country still struggles under the ill-advised one-child policy. That will make growth after the population peaks less exciting, at best. However, that's probably a couple of decades away. More concerning today is the differences between a largely open country like the United States and one that is still largely closed, like China.

For example, it was recently reported by The New York Times that air quality in Beijing was, for lack of a better description, off the charts. Indeed, and this isn't a joke, on a scale from 0 to 500 (0 being good and 500 being the “worst possible”), the air quality above the US Embassy in that city rated 755. While I'm not sure how that's possible, it points out that the environment isn't much of a concern in China.

Additionally, a recent surge in China's reported exports has given some institutional investors pause, questioning the reliability of any information the government provides. If you can't trust the data, how do you know what's actually going on, particularly in a country that is changing so rapidly.

As if it's supposed to make you feel better, Stanford professor Ed Lazear told Bloomberg that, “China’s numbers are nowhere near as accurate as ours, their methodology is simply not at the same level as ours. But we certainly know they’re growing at very high rates. I don’t worry too much about a half a percentage point or even a percentage point one way or another.” A percentage point is a big difference!

Add the issues of censorship and strict government control over just about every aspect of the economy and life, and there are clear reasons to be concerned.

What to Avoid?
If you see the above problems as notable, there are some great companies that you should probably avoid. Indeed, no matter how good a company is, you have to weigh the good with the bad, and for more conservative investors, the bad could easily outweigh the good here.

China Mobile (NYSE: CHL), for example, is a provider of cellular phone service in China and Hong Kong. It is among the largest cell providers in the world, giving it a large base of users and an annuity like revenue stream. However, the company is, basically, state owned. This has likely led to China Mobile's use of technology that isn't an industry standard in the world, which has been a competitive disadvantage of late.

PetroChina (NYSE: PTR) is a major integrated oil company. Although its business is centered on China, its reach is much further than that, as it looks to secure energy resources for its home market. The company is also, basically, controlled by the Chinese government. This has led to some taxation issues that an independent public company might have aggressively lobbied against that PetroChina had little option but to quietly accept.

On the surface, these are both great companies. However, the government's level of control is a problem that could spiral out of control and is already effecting operations.

Some Stocks to Buy
Komatsu (NASDAQOTH: KMTUY) is a well-established competitor to earth moving giant Caterpillar (CAT). The Japanese heavy equipment maker has a leg up on its U.S. competition in China, where it has a material market share. It is a Japanese company, which provides important protections, and it has a global footprint. Moreover, it can boast equipment that is on par with anything Caterpillar makes. Investors looking to tap into infrastructure growth in China may wish to take a look.

Yum! Brands (NYSE: YUM) considers growth in China to be its number one objective, stating that fact publicly to shareholders. Management expects the "consumer class" in the country to double in size by 2020. That represents years of potential growth for a company that has, largely, saturated its mature markets. Yum! has even gone so far as to acquire Chinese fast food concepts to broaden its exposure to the country. A recent chicken quality flap has dragged sales growth in China down and resulted in Yum! shares trading lower, which may make it a buy for more aggressive investors.

Taiwan Semiconductor (NYSE: TSM) is one of the largest chip makers in the world. As a dedicated foundry, it doesn't design chips, instead making the chips that others ask it to make. This is a commodity business, but one in which Taiwan Semiconductor is the 800-pound gorilla. Although economic weakness around the world has been a drag on performance, China is a major market for Taiwan Semiconductor's products, so growth in China is a positive thing for Taiwan Semiconductor.

Indirectly Direct
For investors who want to be “all in” on China but don't want to have the risks of direct investment, there are still options for taking advantage of this long-term growth story. The above examples should keep you away from some of the risks by keeping you invested in companies that are important in China, but aren't actually domiciled there.

Yours,

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ReubenGBrewer has no position in any stocks mentioned. The Motley Fool owns shares of China Mobile. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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