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Invest in China, Not Chinese Companies

Many retail investors outside of China wonder how they can get exposure to the booming mainland economy. They hear stories of venture capital funds making fortunes by investing in companies like (SOHU), China's biggest Web portal, and want to get a piece of the action. Unfortunately for the small investor, there are not many well-run Chinese firms traded on the NASDAQ and other foreign exchanges.

Aside from Chinese online travel service (CTRP) and a few others, I have not seen too many firms in China where an individual can invest, and be comfortable because he understands what he's buying. Investing in Chinese companies that are available to foreign investors can be a treacherous affair. Financial reporting problems often dog major mainland companies. Not only that, far too many Wall Street analysts who peddle investment advice on cable news programs and personal finance magazines in the U.S. have little idea of what's really going on in China.

A far smarter and safer way to invest, in my view, is to look for China plays that aren't Chinese. You can often get exposure to the China growth story by buying in Hong Kong, Taiwanese, and Korean firms that have exposure to the mainland and which are run by Western-trained executives. One popular purchase of late is the iShares MSCI South Korean Index Fund (EWY), an exchange traded fund sponsored by Barclays Global Investors which has delivered roughly a 45% return over the last year.

AVOIDING RISK. This can be a good option, but Korean, and even some Hong Kong companies still don't have the accounting transparency and corporate governance standards that match big multinationals in the U.S. and Europe. These regional markets and companies are also far more volatile as a rule. The most sensible way to buy into China with a reasonable degree of risk is to buy shares of U.S. and European companies with significant exposure to China which are also well run.

In that case you mitigate risk from corruption and accounting issues, back a company that is profitable in various regions of the world, and still get exposure to China. If a U.S. or European company is savvy enough to run a business successfully in China, it can handle just about anything.

Here are three companies worth a look because of their excellent management teams and potential in the marketplace. (Neither I, nor my company, China Market Research Group, own positions in these stocks.)

OFFICE SPACE. Regus Group (RGUGF) is a British-based company -- basically a business center outsourcing firm that arranges workstations, meeting rooms, video conferencing, catering, and technology support for companies at prestigious office buildings in some 60 countries. Their service is ideal for outfits that don't want to invest big bucks in their own office building or get roped into long-term leases. Investing in business centers is a great way to play China's real estate market.

True, skyrocketing real estate prices in some markets like Shanghai can't be sustainable, but business center growth looks certain, given the strong macro-economic outlook for China and the ongoing wave of foreign direct investment by overseas companies.

Foreign firms are rushing into China to set up operations. In January, 2006, alone, 3,044 new foreign firms established operations, according to the Ministry of Commerce. One of their biggest headaches is getting small- to medium-sized office space in Grade A locations. Traffic problems and the belief that companies need to be in a good building to get "face" in China, make the competition to get into a good building in a central location fierce.

VALUED TENANT. Unfortunately for smaller firms, manufacturing behemoths like Sony, and global accounting firms such as Price Waterhouse Coopers are scooping up all the available units in prime locations. Landlords prefer to carve out large blocks of space for big, brand-name tenants. This means small companies must either take an office in a Grade B building, or go into a business center in a prime building.

Regus bought out three of its main competitors in China last year and increased its total number of business centers from 4 to 14. They have another four in Hong Kong, and plan to grow aggressively in China in the coming years. Although revenue from the Asia-Pacific Region generates a small part of the Regus worldwide business, it grew at 33% last year and will continue to be a driver.

Regus charges clients a premium and, frankly, can do so because of the value it delivers. It signs long-term, exclusive deals with landlords in prime locations. It has become a valued anchor tenant akin to someone like Google. The arrival of Regus signals to the marketplace that the building is a prestige address.

GLOBAL EDUCATION. Blackboard is a Washington (D.C.)-based purveyor of educational software making headway in a sector that has had a troubled history in China. Piracy and lack of intellectual property rights has damaged the bottom line for most software companies in China. Although China's three largest personal computer makers recently agreed to load up legal versions of Microsoft (MSFT) software to deflate the market for pirated versions of the company's operating system, the risks for software firms in China are great.

Still, Blackboard's prospects look strong. Back in 2003, the company set up a joint venture called CerBibo with Cernet Corp., a spinoff of China's Ministry of Education. Blackboard sells enterprise level software such as course management systems and transaction cards, to educational institutions. And nearly 100 schools and universities -- including the prestigious Renmin University of China and the Peking University Medical School -- have picked up the Blackboard Learning System offered by the joint venture, to power their online learning setups.

Chinese universities and other institutions in the education sector are more likely to demand the use of legitimate software. Only legitimate software allows for upgrades and gives the university the right to join Blackboard's user community. Professors like to network with professors from around the world and exchange academic ideas. And Blackboard has become the driver for globalizing education.

Blackboard also recently acquired its main competitor, WebCT. (Disclosure: I once did some consulting work for WebCT.) The local producers don't have the stability and scalability of Blackboard -- some classes in China have 10,000 students -- nor do they have international user communities and language packs. Soon, Blackboard will dominate the entire sector as they have in the U.S. (where combined with WebCT's operations it probably controls 70% of the university market), as Chinese universities adopt e-learning.

BIG SPENDERS. Finally, Starwood Hotels & Resorts Worldwide (HOT), the world's biggest hotel and leisure resort chain (it owns the St. Regis, Westin, and Sheraton brands, among others), is expanding rapidly on the mainland. Later this year, the White Plains (N.Y.) company will open the Sheraton Guiyang Hotel in Guizhou Province and new Westin hotel in Beijing.

Starwood brands already has major exposure in China's first and second-tier cities. And the company can sell into all segments of the hotel market, from business travelers to more budget-conscious consumers.

The Starwood Preferred Guest Program, which offers incentives and special services to frequent guests, is clearly No. 1 in the world and has caught on with Chinese clients, too. The company's Chinese guest program membership is in the tens of thousands. And Chinese guests (both local residents and travelers) enrolled in this program spend an average of 20% more in the Starwood hotels than other visitors.

WORTH A LOOK. With the increase of business travel, and tourists flocking to China, international brands will see a huge upswing in demand. The price of staying at the Westin in Shanghai is close to that of the one in New York, yet Starwood enjoys fatter profit margins because of lower labor costs. Moreover, food and beverage sales tend to be far higher than Starwood properties in the U.S., as the company's Chinese hotels have emerged as hubs of business and leisure activities. Starwood doesn't have the accounts receivable problems that other industries competing in China have -- and their staff training is excellent.

For small investors interested in relatively low-risk China plays, Starwood, Blackboard, and Regus are definitely worth a serious look.

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