China Grows

You

probably didn't notice, but while U.S. stocks were pummeled last spring, the markets in China soared. So-called B shares of the 100 or so companies listed in Shanghai and Shenzhen that are open to foreign investment nearly tripled in a four-month blitz. The China rally serves as a reminder that it's wise to own stocks with low correlation to the U.S. But if China is your choice, load up on Dramamine, because this boat delivers one rough ride. Since May, the soaring B shares have tumbled 34%.

The extreme volatility doesn't mean Chinese stocks aren't worth the risk. After all, the B shares are still up 73% this year. With its economy growing 7% annually and with no inflation to speak of, China offers huge long-term promise. It's about to get more attention as it prepares to enter the World Trade Organization and act as host to the 2008 Olympics. Virtually every global company is staking out ground. "If you're serious about growing, you've got to be there," says Dallas-based management consultant William Dunk, who adds that individual investors would do well to take their cues from the likes of Coca-Cola, GM, IBM, Motorola and P&G. All are committed to China.

Consider that China is Kodak's second largest market for film and will probably be No. 1 within a year or two, says Bob Theleen, whose San Francisco-based venture-capital firm, ChinaVest, has been doing business in China for 20 years. The big story now, Theleen says, is the emerging domestic service economy that will set China apart from other Asian economies. Manufacturing, mainly for export, is well developed throughout Asia. Theleen is focusing his China investment on areas like entertainment and fast food.

Despite all the promise, individual investors should go slowly. The capital markets in China are underdeveloped; disclosure requirements and investor protections are shoddy; and the rules are baffling, what with different classes of stock for foreign and domestic investors. Much is being fixed. A shares, which are down 18% for the year, remain available only to the Chinese. But B shares, formerly available only to foreigners, were opened up this year to the Chinese. The resulting buying frenzy is the main reason B shares rallied so strongly.

Chinese regulators are cracking down on rampant insider trading and illegal bank lending for stock investments. A budding mutual-fund industry, seen as one key to the retirement security of hundreds of millions of Chinese, is forcing greater transparency in the markets while adding much needed trading volume to render the markets more efficient and liquid. Yet with so much remaining to be worked out, direct investment in China will probably not make sense for most people for at least another year.

On the other hand, the big money gets made when you invest early and take on risk. Here are several ways to invest in China, starting with the least risky:

GLOBAL CONSUMER-PRODUCTS COMPANIES This is a conservative back-door investment. But after a decade in China, the names you know (McDonald's, P&G, etc.) are succeeding with strong brand recognition.

MUTUAL FUNDS A handful of stock funds target China via direct investment in B shares or through H shares and red chips (Chinese companies that trade in Hong Kong) or Hong Kong companies that do a lot of business in China. For the greatest exposure to stocks that are listed in Shenzhen and Shanghai, go with Investec Mainland China, Matthews China or U.S. Global Investors China Region. Some big companies listed in Taiwan also do plenty of business in China.

ADRS, RED CHIPS AND H SHARES Some of China's biggest companies, including Guangshen Railroad and Huaneng Power, trade in the U.S. as American Depository Receipts. Ten firms are listed on the New York Stock Exchange, one on the NASDAQ. Other blue chips trade in Hong Kong as H shares or red chips, including telecom operators China Mobile and China Unicom. Among stocks trading in Hong Kong, Theleen especially likes the well-run Hong Kong Shanghai Bank and Li Fung, a service firm helping foreign businesses set up in China.

B SHARES Most financial advisers will tell you to forget this dicey game. But if you're determined, U.S. brokerages with Far East offices--and that includes all the big ones like Merrill Lynch and Morgan Stanley--can get you B shares.