China's stock boom
The economy is red-hot, and a flurry of blockbuster IPOs is fueling interest. Here's the smart way to cash in.
By Abrahm Lustgarten, Fortune reporter

(FortuneMagazine) -- Next month the Industrial & Commercial Bank of China plans to offer its stock on the Hong Kong exchange, and global investors are salivating at the prospect. The latest in a string of colossal Chinese initial public offerings in the past year, this one could net as much as $19 billion--more than any IPO on any market ever. And it comes on the heels of lots of similar buzz-generating offerings. In May, Bank of China's IPO achieved a near-record $11.2 billion, and last October, China Construction Bank raised $9.2 billion in its Hong Kong debut.

For years China has been the focus of investors hoping to ride the wave as the vast country revs up its economy and opens to Western business. More Chinese companies are going public, and China's economy continues to sizzle, with 10% GDP growth.

Bumpy ride: Chinese stocks have been volatile.

But the question remains: Are the country's volatile markets and sometimes mysterious stocks mature enough yet for any but the most speculative investors?

While China's growth has been robust and steady, its markets have been anything but: The Shanghai exchange composite index has dropped 24% since June 2001, although it is up 45% in the last year. Stocks on the Shenzhen exchange fell 21% over the past five years, despite a rise of 52% in the most recent 12 months.

This is partly a result of the relative immaturity of China's public corporations. Many companies listed on the Shenzhen and the Shanghai exchanges have been poorly-managed, closed operations hardly accountable to shareholders. State-run banks especially have been plagued by bad loans and politics.

Now China is trying to polish its act. In December the government is expected to open its banking and telecommunications sectors to foreign companies, fulfilling its obligations under the rules of the World Trade Organization. But before it can do that, China has to prepare its own companies to compete. To convince the world of their global quality, the big banks, oil companies like Petro China, and communications giants such as China Mobile are listing not on the mainland Shenzhen and Shanghai markets but on the Hong Kong exchange, which is open to Western investors, and sometimes on U.S. exchanges as well.

The IPO process, which brings Chinese corporations together with big Western banks, allows them to draw on the banks' management, bookkeeping, and governance expertise. "Being listed is a conscious strategy: to have the listing be an agent of change," says Mark Headley, a fund manager at California-based Matthews Funds, which focuses on Asia. "It forces these companies to become global-quality."

In turn the trend is increasingly making China's most stable, robust, and mature sectors available to Western investors. And the resulting influx of capital is helping China's companies grow larger than ever before. Just look at the companies that made Fortune's list of the 100 biggest publicly held corporations in China this year. A company had to have $1.3 billion in revenue to make the list this year, a jump of 22% from last year. Since the ranking shows which Chinese sectors are hot and which are not (yes, there are a few), it's a good place to start for investors eager to understand China's stock opportunities.

The oil sector in China did particularly well. China Petroleum & Chemical, which has reigned as No.1 on Fortune's list for six years, enjoyed a 39% jump in earnings in 2005, and Petro China, which maintained its No. 2 spot, saw profits increase 33%.

One of the biggest movers was computer maker Lenovo, which bought IBM's PC business last year. Its revenues increased fourfold, and it jumped 18 spots, to No. 7. Meanwhile several steel companies saw a drop in profits, and display-screen maker BOE Technology Group, which dropped 14 places to No. 80, posted a $197 million loss.

Careful stock and sector selection

If only investing in China were as easy as just snatching up the stocks at the top of the China 100. Would-be investors have to understand the forces driving China's economy, says Lan Xue, Citigroup's head of China research. In her view the key factor is the exponential rise of China's middle class.

"The most significant development is a purchasing-power increase," she says, pointing to market leaders like China Mobile, insurance company China Life, and Air China as the types of businesses that stand to benefit.

Frederick Jiang, who manages the Ivy Pacific Opportunities fund, likes those sector-leading picks too, but for a slightly different reason. Many "public" companies in China are still state-owned enterprises in which the government keeps as much as a 75% stake. That often means the companies are assured of maintaining their dominant position.

"You want to focus on almost monopoly powers," says Jiang. On the other hand, Jiang steers clear of sectors traditionally thought to be China's strengths: manufacturing and exports. "In China capital is cheap, labor is cheap, and technology is readily available," he says. "We see very fierce competition, and sooner or later profit margins will be eroded."

For Americans, buying individual Chinese stocks has gotten easier. Twenty-two companies on the China 100 are listed on American exchanges, vs. 16 the year before. But that doesn't mean it's wise. "It's a typical emerging market," says Xue. "High volatility and high risk."

Thus, for most Americans the best way to invest in China is to buy one of the growing array of mutual funds or exchange-traded funds focused on the country. Still, Morningstar analyst William Rocco cautions that even China-focused funds are too narrow and volatile for anyone who doesn't already have a broad international portfolio.

One solid choice is Matthews China (Charts), managed by Headley and Richard Gao, a former Bank of China trader. The fund has a 17.4% average return over the past five years and one of the lowest expense ratios, 1.3%, of any China fund. Moreover Gao, who has a solid reputation, has sought out a broad selection of Chinese large-cap and small-cap stocks and tends to stray from the obvious.

The Guinness Atkinson China and Hong Kong fund (Charts) is another strong choice. Conservative as China-oriented funds go, this one strikes a balance between Hong Kong large caps and state-owned mainland power plays like the fresh bank IPOs. It has gained nearly 15% annually over the past five years.

Investors should also consider the three exchange-traded funds that focus on China. ETFs, which are traded like stocks, offer low costs and are designed to track specific indexes. The iShares FTSE Xinhua index (Charts) covers 25 of the largest companies listed in Hong Kong, a selection that ensures liquidity but means any volatility in those top holdings (60% of the index is in the top ten stocks) will be magnified. It's up 27% over the past 12 months.

The iShares MSCI Hong Kong index (Charts) covers the broader Hong Kong index with an emphasis on telecom and finance, and returned 6% in the past year. And finally, the PowerShares Golden Dragon (Charts) covers 57 companies listed on American exchanges that derive the majority of their revenue from China, from Internet company Baidu to oil company CNOOC, and has gained 12% since September 2005. That beats the S&P, but place your orders carefully. Even with these more conservative options, when you grab on to the tail of the Chinese dragon, you have to hang on tight.

The China 100. Top of page