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China's a short-term mess but a long-term buy

Despite current volatility, now is a good time to make value plays in China, experts concur.

It's the question investors around the world are asking themselves today: Should I stay away from Chinese stocks?

A few years ago, people couldn't get enough of companies with Chinese head offices—the country's growth was booming, after all—but a lot sure has changed over the last year.

Since June 12, the Shanghai Composite Index has fallen 38 percent, forcing the government to spend $200 billion to try and prop up the market.

An investor examines the Shanghai Stock Exchange Composite Index at a brokerage house in Beijing, August 26, 2015.
Jason Lee | Reuters
An investor examines the Shanghai Stock Exchange Composite Index at a brokerage house in Beijing, August 26, 2015.

So far, that hasn't worked—the market has dropped 19 percent over the last two weeks—and on Monday the Chinese government said it was abandoning its stock-boosting attempts to focus more on finding those responsible for "destabilizing" stocks.

While it may find a scapegoat to pin the ups and downs on, it's not going to stop the volatility anytime soon.

Much of the news around China's woes have been focused on the Shanghai stock market, which is mostly made up of smaller, domestic companies, including many high-growth tech operations. However, it only started welcoming foreign investors in earnest last November, and it's now experiencing some serious growing pains.

For years, though, people have been buying Chinese stocks on other exchanges, including the Hong Kong Stock Exchange and the New York Stock Exchange, and there are still good opportunities in those markets.

In other words, don't let the troubled Shanghai market keep you from investing, said Jan Dehn, head of research for Ashmore, a London-based investment firm with a speciality in emerging markets.

What's really happening in China? Much of the volatility has taken place on the country's A-shares markets—domestic stock exchanges with Chinese companies—and, in particular, the Shanghai Stock Exchange.

While some foreign investors have been able to buy into Chinese companies listed on the exchange for a while, in November the government made it much easier for everyone to buy stocks on this exchange. They also made it easier for Chinese residents to buy equities on the Hong Kong exchange.

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In the weeks leading up to the opening, local investors, who are notoriously short-term focused, bought up a lot of stock with the thinking that hordes of foreign investors would jump into the market, pushing equity prices higher, said Dehn.

That's essentially what happened. Between November 1, 2014, and the end of last year, the market rose 33 percent. Most of those investors were hedge funds, retail investors and speculators, he said.

"They had no intention of being in the market for any long period of time," Dehn explained. "When a market first opens, you get a whole bunch of speculators who want profits, and that's exactly what we're seeing."

The market's new normal

Institutional investors, such as pension funds and large mutual funds, are often a stabilizing force on stocks, as they tend to stick it out for the long term.

However, they usually take their time to enter a new and unproven market. Until these institutional investors buy in, it's likely that China's domestic market will remain volatile, Dehn said.

There are other issues scaring off investors, too. The renminbi is falling against the U.S. dollar—the government wants to start floating its currency to make it more attractive to foreign investors—it's cutting interest rates, and there's growing concern over the country's economic growth.

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It's this latter issue that could end up scaring investors off the most, said Paul Rogers, director and portfolio manager with Lazard Asset Management, a New York-based investment management firm.

While everyone's aware that the days of double-digit GDP growth are over, the 7 percent growth figure that many people have cited as the new normal is being questioned.

"It's not clear how dramatically things are slowing, but everyone is pretty much in agreement that the growth rate China claims it's having is probably lower and certainly is going lower," he said. "That's having a broader concern globally, since China accounts for 30 percent of global growth."

Shoppers peruse vendors' wares on a street in Beijing
Tomohiro Ohsumi | Bloomberg | Getty Images
Shoppers peruse vendors' wares on a street in Beijing
"One of the reasons why the economy is slowing is because it's shifting from an export-led country to a more domestic one, and those transitions are never smooth." -Paul Rogers, director and portfolio manager, Lazard Asset Management

Despite the jittery domestic markets and concerns over slower growth, there are opportunities for investors, Rogers said, who points out that he only invests in Chinese ADRs or ones listed on the Hong Kong exchange. Some of the names in his Emerging Markets Core Equity Portfolio include the Hong Kong-listed Industrial and Commercial Bank of China and China Mobile, an ADR on the New York Stock Exchange.

One of the reasons why the economy is slowing is because it's shifting from an export-led country to a more domestic one, and those transitions are never smooth, he said. As well, the bigger a country gets, the harder it is to maintain exponential growth.

The long-term story, though, remains. China's middle class is growing, many of them have saved money—China has a 49 percent personal savings rate—and they're going to want to buy more American-style goods, Rogers said.

For long-term investors, all of these fears have made Chinese stocks cheaper. The Hong Kong Stock Exchange, which is where Chinese companies looking for foreign investors have typically listed, is now trading at around 10 times earnings, which is near its all-time lows, Rogers said.

Chinese companies on the New York Stock Exchange have also fallen in value, though they are more expensive than Hong Kong-listed equities, said Louis Lau, director of investments at San Diego's Brandes Investment Partners.

The most expensive stocks are on the A-shares market, which is still up about 32 percent since November. Two of the more expensive stocks are Sany Heavy Industry, a construction machinery company—it's trading at 33 times 2016 price-to-earnings—and Tonghua Dongbao Pharmaceutical, an anti-diabetes drug manufacturer and distributor, which is trading at 46 times 2016 earnings.

Lau also said the best values are on the Hong Kong Stock Exchange, but when it comes to China, investors can't just buy anything. Lau is looking more at domestic-focused sectors today, such as apparel, jewelry, automakers and telecoms.

Dehn is keen on banks, which he thinks will become some of the largest asset managers in the world—Ashmore's All Chinese Equity Fund holds China CITIC Bank—while Rogers is overweight in industrial, consumer discretionary and IT names.

Transparency is key

While the government may want more Americans to buy Chinese stocks, it takes a lot of work to ensure you're getting a good operation. Many companies are still influenced by the government, and transparency can be hard to come by, Lau said.

Many companies are family owned and have subsidiaries set up that benefit the majority shareholder, to the minority owners' detriment. Investors need to look at who owns a company and whether or not they have a positive track record of value creation.

Companies listed on the Hong Kong and New York stock exchanges tend to have higher reporting standards, but they're not immune from shady business dealings either, he said.

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Also pay careful attention to free cash flow. While the economy may be slowing, there are companies that can still grow, but only if they have cash to work with.

That said, understand the objectives of the business. Some companies are only growing to benefit that main shareholder. Make sure the business is reinvesting cash into things like more stores, more plants and other initiatives that truly benefit the business. Sustainable earnings and high-quality management are also critical, Rogers said.

China is still full of risks—the economic slowdown story is not disappearing anytime soon—and Chinese companies will remain volatile. That doesn't mean you should panic, though. If you believe the Chinese growth story and can stay invested over the long term, then there's money to be made.

At some point, even stocks on the Shanghai Stock Exchange will become attractive to the everyday investor. "We're beginning to look at it now," Rogers said. "As these markets stabilize and recover and as we do more research, we'll find good companies."

—By Bryan Boryzkowski, special to CNBC.com