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Is China big enough for U.S. investors yet?

Everyone who's paying attention knows China has grown past socialism and millions have gotten rich. But buying stocks there still sounds exotic to people here.

An investor reads a newspaper near a graph showing the Chinese stock market index at a brokerage in Beijing on Oct. 9.
An investor reads a newspaper near a graph showing the Chinese stock market index at a brokerage in Beijing on Oct. 9.Read moreAP Photo / Ng Han Guan

I was skimming headlines at Bloomberg.com when an ad for HSBC Corp. filled the screen like a news-killing fog.

It urged us to buy China stocks — now! — before the Morgan Stanley stock indexes follow the rival Financial Times indexes in adding Beijing and Shanghai companies over the next couple years and the dumb money from American index-fund investors arrives in billion-dollar waves to inflate share values.

Everyone who's paying attention knows China has grown past socialism and millions have gotten rich. But buying stocks there still sounds exotic to people here.

"Even if you're not ready to invest in Chinese equities, you need to understand what's going on there, because China now drives global growth," said Andy Rothman, investment strategist for Matthews Asia, a $31 billion-asset San Francisco firm part-owned by Radnor-based investment firm Lovell Minnick. Matthews Asia actively manages more than $5 billion in China stocks, more than any other U.S.-based firm, the company says.

Rothman has been active in China for 30 years, starting as a Foreign Service officer. But he sounds like a missionary, repeating China market basics even to sophisticated U.S. investors. Chinese stocks, he noted, are worth $12 trillion, up from $2 trillion 10 years ago. "But when you pick up the paper or go online, nine of 10 stories predict China is going to collapse any day now, for a variety of reasons."

We're past that, he insisted. China is the second-largest global economy. Its state-controlled heavy industry, export manufacturing, and overlarge state-bank-funded real-estate projects have been eclipsed, as to revenues and new investment capital, by new tech and consumer stocks. (The most familiar include Alibaba, "China's eBay," and Tencent, "China's Facebook.") Most new Chinese jobs and most new sales come from smaller private companies.

China stock indexes don't yet reflect that. Matthews China Fund manager Andrew Mattock said his firm makes money for its clients by picking 100 of the most promising of the 5,000 listed China stocks, whose collective price/earnings ratio he estimated at 15, which sounds like a bargain compared with big U.S. stocks.

For sure, there's no shortage of warnings about Chinese business practices or investment risks that go beyond earnings reports. President Trump got investors' attention last month when he shot down the proposed sale of Lattice Semiconductor Corp. in Oregon to a firm controlled by Chinese government investors, citing "national-security risk."

Never mind that Lattice says it makes "zero military product," or that its would-be Chinese buyers had promised to hire 1,000 Americans. The company's shares tumbled, costing Vanguard funds, the Pennsylvania state pension fund, and other investors millions. China's Xinhua propaganda agency said Trump was using the law as "a tool to implement protectionism."

The president and his trade advisers weren't the only ones worried. In February, the Securities and Exchange Commission cited insider trading of Lattice shares as well as those of DreamWorks SKG, which Comcast acquired after outbidding a would-be Chinese buyer. The SEC said a few Chinese investors made millions buying U.S. stocks just before mergers were announced, ripping off U.S. shareholders.

In both cases, the SEC said, illegal trades were led by a China-based Wharton School grad, Shaohua "Michael" Yin, exploiting inside information from Chinese investment bankers. Yin's lawyers were in court in New York last week, arguing the SEC can't prove who said what.

China skepticism is familiar if you've followed short-seller advisers such as  Skippack-based Dan David and Maj Soueidan, whose adventures catching Chinese companies ripping off U.S. shareholders are chronicled in the movie The China Hustle, picked up for distribution by Magnolia Pictures last week. Buying China stocks as HSBC recommends "is an epically bad idea," David told me. "Most of the big-cap [China companies] are state-owned enterprises or frauds by design of the government."

So many Morgan Stanley-backed China firms attracted fraud accusations, David said, he's thinking of a China Hustle sequel.

Matthews Asia says careful investors are finding more sensibly priced bargains as China continues to grow faster than the U.S. or Europe. The view that the China outlook is improving is echoed by the nearly $5 trillion-asset Vanguard Group. It has minimal direct exposure to China, but its FTSE index-based funds, already more China-focused than Morgan Stanley, will be adding more.

"We advise investors to remain patient, yet vigilant," as China slowly improves its markets and legal system and eases foreign investment, Vanguard economist Qian Wang and colleagues Jessica Mengqi Wu and Zoe Bryn Odenwalder wrote in a white paper earlier this year. "In the long term, we remain constructive about China."

But investing there remains tough to track on a big-picture scale, the Vanguard researchers acknowledged. Indeed, China stock returns have "little correlation with economic growth."

That's a sobering admission from a broadly focused index-fund manager. It makes a case for stock-picking China specialists like Matthews.

(Note: Titles for Mattock and Rothman were corrected 10/17/17)