If You Want to Play China…

Strategies for managing risk in an overheated market

If you're worried about investments in China, you're in good company. Last month, Warren E. Buffett liquidated the last of his stake in oil giant PetroChina (PTR ), just weeks before the company staged a spectacular share offering on the Shanghai exchange. "We never buy stocks when we see prices soaring," the Oracle of Omaha told reporters on a trip to China at the end of October.

Chinese stocks have certainly soared. The benchmark CSI index is up more than 152% year to date. And a flood of Chinese companies have gone public as ADRs, or shares on U.S. exchanges, with six that have more than doubled in price over the past year.

So how do you play the white-hot China market without getting burned? Here are some ways.

Chinese stocks may be overvalued, but many analysts think the country's economy will continue to clock double-digit growth for years. That's why Mark Coffelt, manager of the Empiric Core Equity Fund (EMCAX ), advises clients to "go with the companies that sell to China." He favors Korean steel producer Posco (PKX ) and mining giant BHP Billiton (BHP ), both of which benefit from China's demand for industrial materials.

There are even ways for investors to profit from the quality issues plaguing some Chinese exports. European companies such as Bureau Veritas (BVI ), InterTek Group (ITRK ), and SGS (SGSN ) see higher revenues from increasing demand for testing of Chinese exports, says Barry P. Dargan, manager of the MFS International Growth Fund (MQGIX ). "They're growing very well, and there are going to be more and more requirements for testing," he says.

Some analysts favor a low-risk strategy known as pairs trading commonly employed by sophisticated investors and hedge funds. It works like this: You look for pairs of stocks, usually in the same industry, that have very different prospects. Then you buy the better stock and short an equal dollar amount of the more troubled company's shares.

Charles Kirk, a professional investor and author of the Kirk Report blog, screened Chinese equities that trade in the U.S. to look for possible pairs. The screen looked at company fundamentals as well as recent trading patterns.

Kirk came up with 15 high-risk and 15 low-risk stocks. Over the past three weeks, the low-risk group has outperformed the high-risk stocks by 11 percentage points. Possible pairs trades from Kirk's list include buying Shanda Interactive Entertainment (SNDA ) or Ctrip.com (CTRP ) from the low-risk list, while shorting Hurray! Holding (HRAY ) or UTStarcom (UTSI ) from the high-risk side.

For the more bearish, ProFunds, a Bethesda (Md.)-based money manager, has just introduced an exchange-traded fund designed to move twice as much per day in the opposite direction of the FTSE/Xinhua China 25, an index of 25 Chinese stocks that trade in the U.S. It includes giants China Mobile, PetroChina, and the Industrial & Commercial Bank of China. "If you have the view that there's a China bubble, this is a way to turn that to your advantage," says ProFunds CEO Michael L. Sapir. It isn't as risky as shorting stocks, a strategy in which losses are unlimited if the stock price keeps rising. ProFund buyers can't lose more than the amount they spend on the ETF. And ETFs can be held in retirement accounts where shorting stocks is prohibited.

By Aaron Pressman

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