How to Invest in China Stocks

In the history of the world, no economy has made as big of a leap in such a short time as China's has in the last generation. A nation of over 1 billion people that not so long ago relied on the bicycle as its primary form of transportation is now the world's biggest car market. It's also the world's largest smartphone market and is set to pass the United States as the biggest retail market in 2019. China is the world's second-biggest economy today behind the U.S.

According to HSBC, China is set to overtake the U.S. by 2030 to become the No. 1 economy by gross domestic product. The global bank also expects it to be the world's biggest contributor to economic growth through 2030 as it has been since the 2008-09 financial crisis.

Considering China's size and GDP growth rate, which hit 6.6% in 2018, it's not surprising that so many investors are interested in China stocks. In this deep dive look at China stocks, we'll examine the benefits and risks of getting exposure to China, how to analyze Chinese stocks, the options investors have in China, and, finally, the top China stocks to buy.

Image source: Getty Images.

Why you should invest in China stocks

There's one reason above all others that makes China so appealing to investors: growth.

China's economy has boomed over the last generation, in large part, because of the government's planned urbanization of the country and massive investment in infrastructure, including commercial and residential skyscrapers, highways, airports, mass transit, and high-speed rail, among other components. At the same time, globalization has turned China into the world's factory, a manufacturing powerhouse for industries ranging from electronics to apparel to toys, and the gradual liberalization of China's communist government has allowed the economy to harness the forces of capitalism, including outside investment and consumer choice.

The combination of those two forces, as well as technology like the internet and mobile computing, has created a booming middle class in China. As the Chinese populace moves from rural areas to cities, they are embracing the trappings of modern life, including American products like Starbucks coffee, Nike shoes, GM cars, and Apple devices.

Beyond manufacturing, China is now turning into a consumer-driven economy as retail sales increased 9% to $5.6 trillion last year, and Chinese companies are reaping the rewards of the fast-growing economy. With the Chinese government continuing to invest in infrastructure and stimulate the economy, and plenty of Chinese moving to newer, lower-tier cities (what China calls its smaller cities) in the years ahead, China and Chinese stocks should continue to put up outsize growth.

How you can invest in China stocks

Investing in foreign companies isn't always easy. There are risks (more on this below) that investing in foreign countries brings like currency risk, regulatory and transparency issues, volatility, and local-country risks like corruption, war, and natural disasters. But foreign company investors also face logistical challenges.

For instance, buying stocks listed on Chinese exchanges like the Shanghai, Shenzhen, and Hong Kong stock exchanges may require you to open a brokerage account with a Chinese firm, or you can check if your U.S. brokerage will allow it.

Dozens of Chinese stocks are listed on American exchanges through American depositary receipts (or ADRs), which are certificates issued by American banks that represent shares of foreign stocks. ADR's essentially make it easy for foreign companies to list on U.S. exchanges and make their shares available to American investors.

The other convenient option U.S. investors have to get exposure to China is to buy shares in an ETF, an exchange-traded fund. These are funds that hold a group of stocks and trade as a stock would, making it easy to move in and out of. Below are some examples of China ETFs that investors may want to consider.

Data source: Yahoo! Finance.

Finally, another option is buying stocks that trade over the counter or on "pink sheets." These stocks have tickers that include "OTH" or "OTC" and are available to American investors as directly listed companies are. However, they don't face the same reporting requirements from the Securities and Exchange Commission that directly listed companies do, so it may be more difficult to get information on them.

Risks of investing in China stocks

While the growth available in China is clearly appealing, there are a number of risks investors should be aware of, including currency fluctuations, different reporting standards, the influence of China's communist government, and the potential for fraud. For instance, Chinese stocks tend to get attacked by short-sellers more frequently than those of American companies.

The two biggest risks facing Chinese stocks in 2019 are trade tensions and slowing economic growth.

The Shanghai Composite, the index that tracks all the stocks traded on the Shanghai stock exchange, lost 25% in 2018 amid concerns about both the simmering trade war with the U.S. and a sustained slowdown in China's economic growth. Though Chinese stocks have recovered much of those losses in 2019, as the index is up 18% through mid-July, the same risks remain.

In the second quarter of 2019, China's GDP grew by 6.2%, its slowest pace since 1992, as the trade war, internal challenges, and a slowing global economy appear to be having an impact. Meanwhile, trade tensions between the U.S. and China continue to move markets in both countries in a disagreement over trade practices that gradually escalated in 2018 as the Trump administration began slapping tariffs on all imports of a slew of products, including washing machines, solar panels, steel, and aluminum. Though the tariffs were imposed on imports from around the world, China was arguably hardest hit by them as it exports large amounts of those products to the U.S. China responded by slapping 10%-25% tariffs on hundreds of U.S. products. The U.S. then imposed another round of tariffs specifically on Chinese products, with the two sides continuing in a tit-for-tat fashion through May 2019.

At the end of June 2019, President Trump and Chinese President Xi had agreed to a "ceasefire" of sorts, maintaining the current tariffs but planning to renew trade talks and avoid escalation for the time being.

It appears these trade tensions may already be having lasting effects. A number of U.S. companies are moving manufacturing out of China to places like Vietnam, India, and Mexico. If the trade war expands to a potential blacklist of Huawei, the Chinese smartphone maker, China's economy and tech industry could face further pressure. Such a move could provoke a backlash against American brands sold in China, leading to a vicious cycle.

Elsewhere, there are a number of other more general risks to investing in China. For instance, the communist government wields tremendous power, and can easily crackdown at companies at will if they run afoul of China's strict content rules. Such an incident happened to software company Momo earlier in 2019 when its Tantan dating app was removed from app stores and the company was forced to take down a social news feed. On the flip side, if the Chinese market ever opens up to allow companies like Alphabet, Facebook, and Netflix to operate there, Chinese companies now doing well could suffer from the competition.

Finally, the risk of fraud in Chinese stocks is much lower than it was, but investors should be aware that Chinese companies are subject to different reporting requirements regarding their financial statements. This allows unscrupulous companies to manipulate stock prices through their financial reporting and that makes them a popular target for short-sellers. Uxin, an online seller of used cars, was hit by a short-seller in December 2018 and in April 2019 who accused it of fraud.

What are the biggest China stocks?

While biggest doesn't mean best in investing, looking at the biggest China stocks that trade on American exchanges will give investors a good sense of the flavor and variety of investments that they can make in China. Below is a list of seven of the biggest China stocks by market capitalization, showing both companies that are state-owned and privately owned. Market cap is the total market value of a company's outstanding shares of stock.

Data source: Yahoo! Finance and Ycharts.

How to analyze China stocks

When looking for individual China stocks, investors will want to use many of the same tools and metrics they would with any other company to evaluate potential stock purchases. These include the following:

• Revenue growth is always a key indicator of a stock's potential, but it's especially important to consider with Chinese stocks as investors will want to look for high revenue growth of 20% or more, which shows that the company is taking advantage of China's outsize economic growth and capitalizing on the huge addressable market in China's fast-growing middle class, which now numbers around 400 million.

• Competitive advantages also deserve attention from investors as a competitive edge is especially important in fast-growing markets as assets like a well-known brand or network effects can translate into big returns down the road for high-priced and sometimes unprofitable growth stocks.

• Relationships with other companies is also a unique aspect of Chinese stocks and one area investors should pay attention to. For instance, tech giants Alibaba and Tencent hold stakes or have relationships with many smaller companies, including Baozun, Uxin, and JD.com. Considering the interconnectedness of many Chinese companies, having such relationships is one source of competitive advantage, and investors should look for companies that have such ties.

• State-owned vs. privately owned companies and the differences between the two. The most unique thing about China's economy is its embrace of "state capitalism" by which the government owns many of the businesses, especially those in strategic industries like banking, telecom, aviation, and energy, but the economy still functions according to market principles. Many of China's biggest corporations are state-owned, and these stocks tend to be slower-growth dividend payers in more traditional industries. Investors looking for high-growth stocks in China will want to focus their attention largely on tech companies, which are more dynamic and innovative, and tend to be privately owned. Because of that distinction, Chinese tech stocks tend to get the vast majority of investor attention on China.

Top China stocks to buy

The best China stocks will demonstrate revenue growth, long-term opportunities, competitive advantages, and strong relationships with other Chinese companies. Let's take a look at a few Chinese stocks that deserve investor attention.

Alibaba

Of all the Chinese stocks out there, Alibaba may be the best known to American investors, and for good reason. The company built by famed entrepreneur Jack Ma is a tech and e-commerce powerhouse. Its Tmall online marketplace provides a home for a number of high-end global brands like Nike, Estee Lauder, and H&M to sell their goods. The company has forged partnerships with American companies like Starbucks where it's helping the coffee giant with delivery, payments, and online retail.

Alibaba has also built an impressive network of complementary businesses and competitive advantages. Its marketplace model itself creates competitive advantages through network effects and has generated high profit margins for the company. In fiscal 2019, which ended on March 31, Alibaba's China retail marketplaces, Tmall and Taobao saw gross merchandise volume (GMV), or the total value of goods sold on the platforms, rise 19% to $853 billion. That drove organic revenue growth, which excludes the impact of acquisitions, of 39% to $56.2 billion. Including acquisitions, revenue was up 51% in fiscal 2019.

Meanwhile, Alibaba also operates China's leading cloud computing service, Alibaba Cloud, which saw 84.5% revenue growth in fiscal 2019 to $3.7 billion. Alibaba's cloud business is still unprofitable, but it should eventually become a significant profit center as infrastructure-as-a-service business tend to be highly profitable at scale as the success of Amazon Web Services shows.

Finally, Alibaba owns a third of Ant Financial, the parent of Alipay, the payment processing service that has a part in 70% of the company's e-commerce transactions and had more than 700 million users in China as of September 2018 and 900 million globally.

The combination of those business gives Alibaba significant exposure to the fast-growing segments of China's economy and areas that will benefit from advances in technology and the continued embrace of it as more Chinese move into the middle class. Additionally, strong partnerships with brands that sell on its marketplace should protect its value position, and ensure strong profit margins.

Last year, the company posted an adjusted net income of $13.9 billion on $56.2 billion in revenue.

JD.com

Alibaba's chief rival in China, JD.com (NASDAQ: JD) also looks poised to capture the long-term growth opportunity in e-commerce in China. Though JD has its own marketplace, the majority of the company's business comes from direct online sales. Like Amazon, it has invested in an extensive network of warehouses and now has more than 550 warehouses across China. JD also operates its own logistics and delivery service, which it believes to be the largest of any e-commerce provider in China. The company delivers the majority of customer orders itself and offers same-day and next-day delivery to 2,146 counties and districts in China.

JD has also invested in technology like drone delivery and robotics to automate its warehouses, helping to strengthen its delivery leadership. Last year, JD opened a highly automated warehouse in Shanghai that can process 200,000 orders a day. Meanwhile, the company is experimenting with drone delivery in rural China and Indonesia as delivery by drone could unlock parts of China that are hard to access due to poor infrastructure.

JD has forged a number of partnerships with other Chinese companies and global retailers. It formed a strategic partnership with Tencent, which makes JD Tencent's preferred partner for physical goods e-commerce and allows JD to use Tencent's apps to help its users' shopping experience. The company also has a strategic partnership with Vipshop, another Chinese online retailer, in whom it's also an investor.

Outside of China, JD has also teamed up with Alphabet, which invested $550 million in JD and partnered with the e-commerce company to combine JD's supply chain and logistics expertise with Google's technology prowess. JD has also formed an alliance with Walmart, which owns 9.9% of the company, and the two have collaborated on one-hour delivery from Walmart stores in China and to launch online stores from Walmart, Sam's Club, and Asda on JD.com.

JD's strengths in delivery and logistics combined with its expansive partnerships should allow the company to continue to capitalize on the long-term growth opportunity in Chinese e-commerce.

Tencent

Along with Alibaba, Tencent is China's other dominant tech giant, and together the two companies have a role in nearly every corner of China's tech industry.

Rather than e-commerce, Tencent rose to become one of China's biggest companies by dominating social media and gaming. Its leading social network Weixin, or WeChat as it's branded internationally, finished 2018 with nearly 1.1 billion monthly active users. QQ, its other social network, had another 807 million users. The size of those apps has given the company a very sticky and valuable platform from which to add on a wide variety of money-making components, including advertising, mobile gaming, video streaming, and mobile payments.

Last year, those businesses drove revenue up 32% to $45.6 billion and delivered net income $11.7 billion, and allowed Tencent to pursue a number of growth opportunities in high-margin businesses like advertising, mobile payments, and cloud computing. Online advertising revenue jumped 44% last year to $8.47 billion, driven by 55% growth in social advertising from new products like Weixin Moments, Mini Programs, which are essentially sub-applications within the app, and its mobile advertising network.

In its other business, which is primarily made up of mobile payments and cloud computing, revenue jumped 80% to $11.4 billion, driven by an increasing take rate from commercial transactions and an increase in other fees as the number of active users increased significantly from the previous year. In its emerging cloud business, revenue more than doubled to $1.3 billion, as cloud remains a valuable long-term opportunity.

Growth in its biggest segment, online games, has been slower lately due to a temporary halt in new game approvals. However, gaming is still expected to be a rich source of growth in China as UBS forecast that annual spending on gaming in China would more than triple by 2030 to $200 billion.

Additionally, Tencent holds a massive portfolio with investments in more than 700 companies, many of which are expected to go public soon.

Tencent may seem like a sprawling enterprise, but no Chinese stock gives exposure to a wider range of growing and interconnected segments in the Chinese economy in areas like social media, gaming and entertainment, mobile payments, advertising, and cloud computing.

Ride the dragon

As the Shanghai Composite's sharp drop in 2018 shows, Chinese stocks can be volatile, and the market is going to favor growth investors over value seekers. However, no market can offer the kind of expansive, long-term growth opportunities that China can. This is the world's most populous country and hundreds of millions of its citizens are still expected to move up into the middle class as the government remains focused on urbanization and making the country a high-tech powerhouse.

Despite some challenges, China's growth should continue to outpace that of the developed world and bring investors plenty of opportunities as it expands. Whether you're considering individual China stocks, a China ETF, or just American companies with Chinese exposure, the upside potential of investing in China is too great to ignore.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Jeremy Bowman owns shares of Amazon, Facebook, General Motors, JD.com, Netflix, Nike, Starbucks, and Uxin Ltd. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Baidu, Facebook, JD.com, Netflix, Nike, Starbucks, and Tencent Holdings. The Motley Fool has the following options: short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool recommends Momo and Uxin Ltd. The Motley Fool has a disclosure policy.

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