World Markets

BRIC by BRIC: The Best Way to Invest in China Might Not Be in China

Suzanne McGee
John Phillips | CNBC

China has just harvested a bumper crop of millionaires. The number of Chinese individuals who became dollar millionaires (counting only their liquid wealth, not real estate) soared 82 percent last year to hit 2,378,000, according to just-released data from the Boston Consulting Group.

The twist to the tale? They probably didn't make that money by investing in the Chinese market.

While China remains the world's fastest-growing economy, helping to generate incredible amounts of wealth for those at the very top of what is becoming, with every passing year, an ever more unequal society, it also wrapped up 2013 as Asia's worst performing stock market. The Shanghai Composite posted a decline of 6.75 percent.

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Nor is this disappointment a thing of the past. So far this year, the Shanghai index is down nearly 3 percent. By comparison, India's Mumbai Sensex is ahead more than 20 percent, and even Brazil's Bovespa has climbed 7 percent. Even Russia's Micex Index, in spite of the country's economic and geopolitical woes, is doing better. It's essentially flat for the year to date.

Within Asia, Thailand – where political unrest has taken a deep toll on economic growth and where the military recently seized power in a coup – is seeing its stock market fare quite well. The ThaiDEX SET50 ETF, an exchange-traded fund often used as a proxy for the Thai market, is up almost 14 percent year to date.

The problem is, as Goldman Sachs pointed out in a recent investment strategy report, that reasonably rapid economic growth – something China still boasts, even as it struggles to meet its own 7.5 percent GDP growth target this year – doesn't always translate into earnings growth or share price gains. In the two decades leading up to 2013, economic growth in China has dwarfed that of the United States — but U.S. stock market returns outpaced those earned in China to an equally dramatic extent.

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There are many theories for why this is. The state continues to play a big role in business and puts its interests ahead of those of maximizing shareholder profits, for instance. Management skills may be weaker, too. None of that is likely to change any time soon. What has happened instead is that China's government appears to be at war with itself, trying to balance the tightly regulated and low-cost "official" lending system (a political necessity) with unintended consequences such as the creation of a massive shadow banking system.

Last year, the China Banking Regulatory Commission calculated this network of non-bank lenders accounted for a whopping 80 percent of the country's GDP. Even if the actual figure is far lower, fears about potential abuses in the murkier parts of this shadow banking network, along with anxiety about the impact of any collapse in asset values, are enough to spook many investors.

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Bull vs bear: China's economic outlook

China's current pattern of economic growth and regulation fuels the growth of its shadow banking system – and is great for those who make millions from that system – but it's bad news for anyone hoping to find a quick, straightforward way to profit from what is still the world's fastest-growing economy.

Alas, that title isn't all that it used to be. True, exports are still healthy and growing; factory output is on the rise. But investment levels remain lackluster and big question marks hover over China's potentially problematic property sector.

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Moreover, China's reforms are aimed at boosting domestic consumption. That might suggest that investors rethink the question from a different angle. Instead of eyeing the Chinese market, perhaps it's time to winnow through the universe of global stocks — whether based in China, Southeast Asia, or the developed markets — in quest of companies that might benefit if that long-cherished policy goal finally reaches fruition.

There is at least the potential for a portfolio of consumer-oriented businesses to mimic, to some extent, the experience of commodity manufacturers over the last decade, as the boom in China's manufacturing and industrial production triggered an unprecedented demand for everything from iron ore and copper to rare earths mined in Africa.

That boom has now turned into a bust, leaving mining companies facing large losses and grappling with overcapacity. The question is whether the centuries-old dream of selling consumer goods to China's massive population might finally come true, and in the process become the best way to invest in at least the idea of China, if not the country itself. We may yet end up in a world where the best "China stocks" aren't Chinese at all, but those of companies like Procter & Gamble, Yum! Brands or Nike.

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Suzanne McGee, The Fiscal Times