China: Screaming Deal or Value Trap?

Most international investors have had their attention focused squarely on Europe for the past several months, as nations on the continent grapple with a sovereign debt crisis that threatens the viability of the euro as a common currency. Yet while the uncertainty surrounding Europe has deservedly undercut stocks that rely on the eurozone for their markets, some analysts believe that one emerging economic power has quietly gotten to the point at which it's more undervalued than ever.

Walking the Great Wall
Burton Malkiel is no stranger to the ups and downs of stock markets. As the author of A Random Walk Down Wall Street, Malkiel understands how markets move in and out of favor, alternately presenting attentive investors with opportunities to buy low and sell high.

Recently, Malkiel gave a speech in which he said that he has never seen more attractive valuations for Chinese stocks. As CNBC reported, Malkiel believes that between huge infrastructure spending and an improving standard of living for a growing middle class, China still has the potential to become a much larger player on the global economic scene. Moreover, as China's own population increases their domestic spending, the emerging market's economy won't be as dependent on exports and foreign consumption as it is today.

In Malkiel's view, those trends support a boost in allocations to Chinese stocks. With China's share of global GDP weighing in around 9%, typical institutional allocations come in at about 1.7%. That leaves plenty of room for upside.

A tale of two markets
But China's stock market is more complex than a cursory look might reveal. Even with the iShares FTSE China 25 ETF (NYS: FXI) down 18% in the past year, the country's stock market pullback hides two very distinct pockets of the market.

On one hand, segments like technology continue to perform well, even despite the Chinese government's own meddling. Baidu (NAS: BIDU) and SINA (NAS: SINA) have put in decent gains over the past year, as excitement about China's Internet market has led to massive (though not always profitable) IPOs from Renren (NYS: RENN) and E-Commerce China Dangdang (NYS: DANG) . Similarly, although China Mobile is flat for the year, smaller competitors China Unicom and China Telecom have risen sharply.

But other sectors of the Chinese market have done horribly. China Life (NYS: LFC) is down 45% on the year, and aluminum maker Chinalco (NYS: ACH) has lost more than a third of its value. In addition, multiple scandals involving Chinese companies listed on U.S. exchanges through reverse mergers have led to big doubts about the veracity of China's domestic economic boom.

Buying the right stocks
As Motley Fool international expert Tim Hanson has said before, successfully investing in China requires going beyond the exposure that most ETFs give you. With overexposure to risky financial stocks -- the iShares China ETF has almost half its assets in financials -- as well as energy plays, ETFs largely ignore consumer stocks. Yet those are exactly the stocks that will benefit most from internal growth in emerging market nations.

Malkiel clearly thinks the same way, as he has developed several indexes of Chinese stocks that are more broadly invested, without the focus that other ETFs have on financials and energy stocks. Moreover, with ETFs available that target the Chinese bond and currency markets, investors can bet on continuing appreciation of the Chinese currency against the U.S. dollar -- and thereby potentially get extra return on top of any rebound in China's stock market.

The long-term play
With a potential slowdown in China's economy coming, many investors are reluctant to commit money to its stock market right now -- especially as other markets around the globe rebound. But over the long haul, China will play an increasingly vital role in the world's financial matters. Taking a rare opportunity to grab bargains will likely reward you over time.

China isn't the only emerging market that looks good right now. Check out the Latin American company that the Fool identified as the hottest IPO of 2011 in this free special report.

At the time thisarticle was published Fool contributor Dan Caplinger has never been to China, but he'll make it someday. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of China Mobile. Motley Fool newsletter services have recommended buying shares of Baidu, China Mobile, and SINA. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy is good around the world.

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