The Safe Way to Profit on China
By Jeff Clark
October 2, 2007

The stock market doesn't often reward the majority. But sometimes it does so just long enough to get the minority to rethink its position.

Think about Internet stocks back in 1999.

Smart investors knew it was a bubble. Smart investors knew there was no logical way to justify the stock prices. And smart investors were the wallflowers huddled in the corner at the holiday Christmas parties while everyone else celebrated the riches of the new paradigm.

Super smart investors lost a fortune trying to short the sector.
By March of 2000 everyone – along with super smart investors - was convinced that we were in a new era and traditional stock valuations didn't matter. That's exactly when prices topped.

We saw the exact same thing last year with real estate.

In 2005, the public loved real estate. Smart investors saw a bubble and warned of a potential downfall. But prices kept going up. Holiday parties were filled with visions of sugarplums dancing and home prices rising. And anyone who hadn't refinanced their primary residence and plowed the proceeds into a duplex in Las Vegas or Phoenix was left cowering in the corner sipping eggnog and mumbling something about home prices having to come down at some point.

By mid-2006, even the smart investors capitulated and accepted the inevitability of perennially higher home prices. That's exactly when prices topped.

Today, China is on everyone's mind. The Shanghai stock index is up over 100% in the past 12 months. The public is moving into the sector, and smart investors are warning of a bubble.
But, like Internet stocks in 1999 and real estate in 2005, the smart investors are too early.

Yes, Chinese stocks are way up. Yes, the valuations are bordering on the ridiculous. And, yes, a bubble is building.
But it's not ready to pop – not yet, anyway.

The public is just now noticing China. The average investor looks at China right now like a fattened trout looks at a dragonfly. Sure, it's a tasty morsel, but we're so full already that it's hardly worth the effort to chase after it.

The public is curious, but not quite ready to take the bait. It's the exact same setup we saw with Internet stocks in 1999 and real estate in late 2005. And both of those situations led to huge final rallies that sucked in the public at the top and led to tremendous short-selling opportunities.

We'll have that opportunity with China within the next few months. But, between now and then, you have to own China.

The final rally in a bubble-filled sector can lead to huge gains. Shares of Yahoo! (YHOO) gained 400% between mid-1999 and early 2000. Investors in Toll Brothers (TOL) – one of the nation's premiere homebuilders – enjoyed gains of almost 100% in mid 2005 as the real estate bubble sucked in its last gasp of helium.

We're likely to see the same thing happen to Chinese stocks over the next few months.

It is, however, difficult to recommend shares of Bidu.com (BIDU) – China's top Internet company – as they trade at 175 times earnings. Buying shares of China Finance Online (JRJC) – which operates at a loss, though shares are up 800% since May - is equally insane.

Both of these stocks will probably go higher over the next few months as the China bubble runs its course. Neither, of course, is a low-risk investment.

The trick to playing China right now is to find a stock that will benefit as investors flood China with new money, but is fundamentally cheap enough to keep the downside risk to a minimum. That means looking for a profitable company with no debt, lots of cash on the balance sheet, and a technical pattern that's just beginning an uptrend.

Only a few companies fit this formula. I shared one name with S&A Short Report readers yesterday, and I'll recommend a few more over the coming weeks.

The China bubble will probably play out like Internet stocks or the housing boom... We'll see one more explosive move higher over the next few months. But there's risk, too. Pick the wrong stock or stick around too long, and you just might blow up your portfolio.

Best regards and good trading,

Jeff Clark