A Better Way to Play China's Promise - TheStreet

A Better Way to Play China's Promise

Surprise! Look across the Formosa Strait for this one.
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China's economic rise is not a new story, but the listing of an exchange-traded fund tracking Chinese stocks is a relatively new development -- and if assets are any guide, a popular one.

Since listing in late 2004, the

iShares FTSE/Xinhua China 25 Index fund

(FXI) - Get Report

is up more than 100% and counts more than $5 billion in assets.

But what are you really buying? Does this index of 25 Chinese stocks (all listed in Hong Kong, commonly called "red chips") provide you with the growth you'd expect from China? Do the companies really benefit from China's emergence as the world's factory floor? And if so, at what price?

In sum, not really. I've found an ETF that does a better job of capturing the manufacturing promise that is China -- and it's not where you might expect it.

But first, let's dig deeper into the China 25 fund.

In reality, the companies in the China fund are domestically oriented. Although they benefit from the emergence of a Chinese middle class over time, the companies in the index see little direct benefit from China's manufacturing prowess.

The sector breakdown below illustrates this point. Financials represent about 44% of assets in the FTSE/Xinhua index, while telecom and energy firms each represent about 20%.

All are primarily plays on China's domestic economy. Chinese banks too often lend to state-owned enterprises and real estate developers based on political directives -- perhaps not such prudent investments.

At any rate, manufacturing by multinational firms located in China is primarily financed by direct foreign investment, so Chinese banks don't stand to gain much, at least not directly.

We also know China's banks hold a considerable amount of non-performing loans, but no one knows for sure how bad the situation is.

As a result, this could be a dangerous concentration of risk if there is ever a financial crisis.

FTSE/Xinhua Sector Breakdown

Source: AltaVista Independent Research

Telecom is an obvious play on domestic demand: millions of Chinese who still don't have a cell phone will buy one when they can afford it. Demand for energy will grow along with the domestic economy, and this sector does benefit from manufacturing activity because factories need power.

But as big importers of oil, Chinese energy companies are exposed to the ups and downs of the world oil markets, yet they are constrained by government mandates on what prices they can charge domestically. (Predictably, this led to scattered shortages and long gas lines last summer.)

So what you really have in the China fund is a basket of companies that benefit from the gradual development of a Chinese middle class, navigating an obstacle course of government meddling along the way, but nothing that is really a play on what China is known for -- its manufacturing capability.

Not to despair: There is more than one way to skin a cat. We believe the

iShares MSCI Taiwan Index fund

(EWT) - Get Report

is a better way to play the growth of Chinese manufacturing -- and from a valuation perspective the fund also appears to be a better investment.

How is it that the Taiwanese market is a play on Chinese manufacturing? Few countries are as heavily invested in China as Taiwan. Economic ties between the two political rivals are strong.

According to Taiwan's Mainland Affairs Council, China now accounts for nearly 70% of all Taiwanese outbound investment. Meanwhile, trade between the two has exploded in recent years to an estimated $86 billion in 2006, and now amounts to about one-quarter of Taiwan's total foreign trade. Much of this trade consists of Taiwanese components being shipped to and from China for manufacture or final assembly before export to markets around the world.

Taiwan-China Trade
In billions of dollars

Source: Mainland Affairs Council, Republic of China

The Taiwan fund comes with its own concentration risk: Taiwan is all about technology. But this too is really a play on Chinese manufacturing. Despite Taiwanese government efforts to slow the trend, the largest chunk of Taiwanese investment in China -- over one-fifth -- is destined for high-tech manufacturing-related industries.

Barely a month goes by without one of Taiwan's chipmakers breaking ground on a new foundry in China.

Apple's

new iPhone will be manufactured in China by Hon Hai Precision (the ETF's second-largest holding). Americans aren't the only ones outsourcing production to China; the Taiwanese are pretty gung-ho about it too.

MSCI Taiwan Sector Breakdown

Source: AltaVista Independent Research

To be sure, jumping on the outsourcing bandwagon does not necessarily make a company a good investment. However, valuations suggest that, despite the fact that the Taiwan fund actually gives you better exposure to the growth of Chinese manufacturing than the China fund, it may also be a better bargain. The Taiwan fund trades at a P/E of 13.5 times estimated 2007 EPS, compared with 17.1 times for the China fund.

P/E Ratios On 2007E EPS

Source: AltaVista Independent Research

Despite the fact that it has been around for several years longer -- it was launched in June 2000 -- the Taiwan fund is less than half the size of the China fund at $2.24 billion.

Of course, integration of the two economies is not without risks, especially of the political type. But it is important to remember that there are vested interests on both sides, because China gains much-needed investment and employment for its citizens.

At the end of the day, for those who missed out on the rally in the China fund but still want to be in China, there's a detour -- and it runs through Taiwan.

Michael Krause is president and founder of AltaVista Independent Research. AltaVista provides fundamentally driven analysis of exchange-traded funds to help investors select ETFs based on investment merit, much the same way they would evaluate a single stock. The firm offers both print and online ETF research to subscribers, but does not manage clients' money. Mr. Krause is also a frequent contributor to broadcast and print media.