NEW YORK (TheStreet) -- On Nov. 17, China removed the barriers between the Hong Kong and Shanghai stock exchanges, opening Chinese domestic shares to foreign investors. That reduces the games played between different classes of Chinese shares and enables us to evaluate them on an equal basis with other possible investments. With such evaluation, it becomes clear that a wise investor will include a modest but growing Chinese component in his overall portfolio.
A thoughtful approach to China suggests investment in the Guggenheim China Small Cap ETF (HAO) - Get Report , which invests in Chinese companies with a float of less than $1.5 billion and attempts to match the performance of the AlphaShares China Small-cap Index.
The Shanghai Composite Index closed Friday at 2,938, up 35% on the past year and up more than 19% on the day the market was opened to foreign investment. Some have suggested the market might be in a bubble, but when you look closer, that appears unlikely. The index is below its levels touched in 2009-2010, when stock markets globally were just beginning their long recovery. It's trading at less than half its all-time peak in October 2007.
It is also less than double its level 15 years ago. In addition, the market claims to be on an average price-to-earnings ratio of only 14.4, well below the levels in New York (but more on the "E" in that P/E below). Given the extraordinary growth in the Chinese economy and stock market over the last couple of decades, the market looks under- rather than over-valued.
The problem with China has always been the dodgy numbers. The country in recent years has claimed economic growth of more than 9% in some years. However a lot of that was "white elephant" real estate projects that now sit as a dead weight on bank balance sheets. Since Chinese GDP numbers have traditionally appeared on the day after the end of the quarter, unlike U.S. figures, which appear a month later and are subject to big revisions, you can suspect there's a fair amount of making-up-numbers involved, in an effort to meet some of the "Plans" which the nominally Communist government dreams up.
Still, even without the fudging, you can look at figures like automobile sales or electricity consumption. China is now the world's largest auto market by a substantial margin, and still growing. Much of the country's increased prosperity is real, and there's money to be made there if we're careful.
As was notorious a couple of years ago, Chinese accounting can also be fraudulent, even when international auditors are involved. I suspect that's partly a legacy of their decades of making up numbers to satisfy a Plan; they think they can get away with the same nonsense with Western investors. Over time, this should improve a bit (for one thing, the international auditors have a substantial risk of investor lawsuits -- as they should have.)
That leaves us with a dilemma. Large Chinese companies are subject to the whims of the government, often still a part-owner, and may not be properly run. Small Chinese companies are the growth engine of the country's remarkable emergence, but some of them may be scams.
The solution is to buy a fund like HAO. It may spot some of the scams (as may AlphaShares, which designs the index) but it will at least give us the strength of diversity, getting us close to the profits available from China's rapid true growth. With assets of $225 million, an expense ratio of a moderate 0.76%, a P/E ratio of a very reasonable 11 times and a 2% yield, it looks like a sensible way to get a modest exposure to China's growth.
This article is commentary by an independent contributor. At the time of publication, the author held HAO.
TheStreet Ratings team rates YAHOO INC as a Buy with a ratings score of A-. TheStreet Ratings Team has this to say about their recommendation:
"We rate YAHOO INC (YHOO) a BUY. This is based on the convergence of positive investment measures, which should help this stock outperform the majority of stocks that we rate. The company's strengths can be seen in multiple areas, such as its compelling growth in net income, revenue growth, largely solid financial position with reasonable debt levels by most measures, notable return on equity and reasonable valuation levels. We feel these strengths outweigh the fact that the company shows weak operating cash flow."
You can view the full analysis from the report here: YHOO Ratings Report