How to Invest in China: Five Myths Stock Investors Should Ignore

China’s phenomenal economic growth is no news to anyone. Many investors, however, missed out on the action as they did not feel they knew enough to get started. I recently met with veteran China stock fund manager Martin Lau at First State Stewart and our discussion touched on some of the myths about investing in China.

Lau’s China funds have won a lot of praise in investment circles. I have followed his China funds for some years and liked his “steady-eddy” approach. Hopefully this blog post could help ease some of the undue concerns about investing in China.

Myth 1: China investing is limited to stocks listed on the exchanges in China or companies domiciled in China.

Lau believes the best investments, or the biggest beneficiaries of China’s growth, are not necessarily Chinese companies or China-listed stocks. His team invests mostly in stocks that are listed in Hong Kong. They’ve also invested in companies listed in Taiwan, Japan, and even Australia and the United States, because they may benefit from the China growth story.

By way of background, some of the largest Chinese companies, such as Tencent, are listed in Hong Kong so as to tap into the international capital market. Some, like China Mobile, are dual-listed in Hong Kong and New York.

My Takeaway: Invest in companies that benefit from China’s growth. Where they are based or listed does not matter.

Myth 2: China index funds or exchange-traded funds (ETFs) have performed in line with the Chinese economy.

Index funds are often investors’ first choice when investing in an unfamiliar country or sector, either for strategic or tactical allocation purposes. This generally makes sense as country and sector indices typically offer broad diversification in the targeted markets. Unfortunately, this is less the case in China.

Lau pointed out that, for the last 20 years, while China has been an economic miracle, the MSCI China Indices have basically been flat. There are many reasons for this, not the least of which is index composition. The private sector and foreign investments have been strong drivers of economic growth in China. MSCI China, however, is made up of mostly — over 90% — state-owned enterprises. Financials, such as the big banks in China, account for about half of the market cap.

My Takeaway: Investigate your options for investing in China. Index funds and ETFs are not your default choices.

Myth 3: Investors need to understand politics to do well picking investments in China.

Investors generally believe that politics play an important role in China. For bottom-up investors, however, the impact of politics may not be as critical as it is made out to be.

“If you invest in consumer companies, the role of the government is relatively little,” Lau said.

He does think politics can be very important for regulated industries, such as oil and telecom. At the strategy level, the current administration’s attitude toward economic reforms can also have far-reaching implications.

“I think the fact that the government is less focused on short-term economic growth is negative for the economy in the short term, but it could be quite positive for the long run,” he added.

My Takeaway: Understanding politics is important, but it is not a prerequisite for investing in China.

Myth 4: Investors need to have local connections to do well investing in China.

“Guanxi,” or connections, can be so powerful in China that the word is practically as well-known as “nihao,” or “hello,” in business circles around the world.

Lau does not base his investment philosophy on information. Traders tend to be more information-driven. Their focus is clearly short term and their turnover is high, neither of which seems like a good idea from a long-term investor’s perspective.

“China is a big country and the business practices in different parts of the country are quite different,” Lau commented. It is indeed a challenge for international investors to build an information edge even when they want to.

My Takeaway: You can be successful investing in China even when you are not well connected — you do need to know your edge though.

Myth 5: The Chinese accounting framework is so different that it is not particularly relevant for investors.

For most people, reading financial statements is not fun. Just the thought of reading Chinese financial statements probably kept millions of potential investors away.

Accounting experts do not think the issue is with the framework, which has been converging with international standards over the last three decades, but with the execution. (For more details on this, read a related book review: “How to Read between the Lines of Asian Financial Statements.”)

Lau thinks investors will do well to act carefully and use commonsense when reading financial statements. If things look too good to be true, they probably are.

My Takeaway: Don’t let the fear of reading Chinese financial statements stop you. Focus on making sense of the numbers compared with the stories from the management.

In summary, investing in China is not “easy as pie,” but it might not be as daunting a task as you think. If you are ready to get a taste, stay tuned for the second installment of this series, “Where to Invest in China: Four Powerful Trends Long-Term Investors Can’t Ignore.”

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Image credit: ©iStockPhoto.com/Robert Churchill