Everybody knows about China.

It's the place where cheap junk is made. Where toys and sneakers are glued together and cheap clothes spun out. Even tourists in Japan looking for gewgaws for their aunts are often chagrined to see the words "Made in China" on them; such is the might of the country's export market.

China is stereotyped by investors, too, who have in the past mainly invested in it for the strength of those exports. "That's what provided their whole movement is giving cheap labor to the world," says Jim Trippon, the Houston-based editor of the China Stock Digest.

Otherwise, investors have used it as a proxy play for commodities. The country's voracious hunger for items such as oil, iron, coal and copper to build its rapidly urbanizing infrastructure has made China one of the drivers of global commodity prices. The country is so in sync with commodities, some say the safe play is to short them if you think China's economy will tank.

But there are two Chinas. You can either look at it as the country with a 53% rural population mired in the past, a country that still mainly pumps out cheap stuff for other nations. Or you can look at the China of the future: a country with a growing middle class, an incubator for a massive consumer culture with flashy brand names for cars, sporting equipment, clothes, desktop computers, cell phones and lotteries. As the population urbanizes and GDP grows, the country has all the critical mass for an economic supernova.

This is the country that has long-term investors more piqued. China has now surpassed Japan as the world's second-largest economy. It has become the world's largest car market, passing the United States, and some observers now call it the world's largest consumer of energy, too. Furthermore, the country's GDP has continued to grow steadily in the 9%-10% range, even during the economic crisis, while the United States' GDP is huffing and puffing. The real U.S. GDP was negative 2.4% in 2009, and it grew only 1.7% in the second quarter of 2010. The World Bank predicts China's gross domestic product will climb 9.5% in 2010 and 8.5% in 2011.

"I remember when I was a broker of Australian stocks ten years ago," says Andrew Sleeman, a portfolio manager of Franklin Templeton Investments' Mutual International Fund in Short Hills, N.J. "It was all about an Asian company's exposure to the U.S. It's not about that anymore. Now it's the exposure to China. I expect that to continue to be the case."

China itself is now encouraging this trend, having launched a 4 trillion yuan stimulus package in late 2008 to spur internal demand after watching its export markets collapse (an amount that totals about $586 billion). That collapse led to thousands of factory shutdowns and a rise in unemployment. The Chinese government has vowed not to let it happen again, and has made moves to "decouple" somewhat from the global economy.

 Richard Gao, a portfolio manager at Matthews International Capital Management LLC, who helms the company's China and Pacific Tiger funds, says the government's gambit has so far paid off, as internal consumption has continued to soar after the export collapse. The retail sales figure in China has grown at an average of 16% to 17% over the past five years on average, he says, even amid global financial upheaval, and the average income has also been growing at 12% to 13%.

What does that mean for investors?

"China has stated its intention to build its own internal consumer-driven demand," says Paul Hechmer, the CIO and founding partner of del Ray Global Investors in Los Angeles. "So it may not be important to own companies that make tennis shoes. It may be more important to own the banks and the companies that benefit more from internal growth."

According to Trippon, China's shift means products of higher value, and thus more skilled manufacturers, salary increases and a bigger middle class. This will have dramatic effects for the surrounding countries as well. With the higher standard of living in China, cheaper labor will shift to countries such as Vietnam, he says.

"What has happened is that manufacturers looking for unskilled labor at low costs have been moving jobs out of China to Vietnam," says Trippon, "and China is actually OK with that. Because what they're looking for is jobs with higher value added, where they can maybe have steel workers get a higher income potential rather than just being a low-cost contract manufacturer."

Long-Term Gain, Short-Term Pain
But while China will inevitably grow in the long term, it's also got growing pains, including volatile stock prices, speculation and overheating. Western investors balk at its opaque business operations, which make the companies hard to value. China gave a lot of money to banks (and unlike the U.S., forced them to lend it, Trippon says). This has led to a too-giddy property market, investors fear.

"There is some overheating in the [property] sector," says Gao. "It is a very important part of the Chinese economy. It accounts for about 25% of the overall economic activity in China. Any significant slowdown or overheating in the sector could have a very big impact on the overall economy." He points to the cities of Beijing, Shanghai and Shenzhen especially as vulnerable, but he says the second-tier cities have seen less irrational exuberance. He also says the government is aware of the problem and has tried to tap on the brakes with tightening measures-stricter lending standards for borrowers, for instance.

The government's willingness to throw hundreds of billions of dollars (more than a trillion with provincial government help) has shored up GDP, but it could also mean a severe hangover as banks find themselves with a lot of loans on their books that won't be paid back, especially for the overheated real estate market.

That has ramifications for Chinese index investors particularly, because financials make up a great deal of the Chinese indices, and these companies are most vulnerable if the Chinese real estate market tanks. "It's pretty much acknowledged around the world that these financials, these banks hold a bunch of real estate that will probably never pay them back," says Hechmer, "So some might say, I really want to be in China, but I don't want to be in the banks."

"We pay no regard whatsoever to the indices," says Sleeman, "And it may or may not surprise you to hear that we don't have a lot of exposure in those areas right now, particularly on the financial side. Our concern on the financials is the lack of transparency in Chinese bank balance sheets. Beyond that, the price of the Asian financials at this juncture aren't cheap enough for us and we're pretty cost conscious."

If the market tanks and financials and property stocks underperform, it would cause longer-term trouble, says Sleeman, undercutting consumer confidence and harming the current Holy Grail of long-term internal consumption growth.
Inflation is also something to be wary of, according to Sleeman, mainly because food makes up a greater part of the inflation index in developing countries like China than it does in developed countries, and food-related items are rising in price because of global droughts and changing Chinese diets. Gao says that even though the CPI is still a reasonable 3.3%, that's a sharp snap back from the negative 2% deflation China suffered in the second half of 2009, and so it's something to be wary of.

How To Play?
The lack of transparency, the inflated stock prices and the unrepresentative indexes mean there's a certain amount of hunting and foraging investors must do if they want to go into China. Most Western investors, barred from investing in mainland China directly, go in through the Hong Kong and New York exchanges. The good news is that it's easier to get transparency that way. But it doesn't make it easy to get into every sector or get a complete snapshot of the long-term Chinese boom.

The first impulse of investors wanting to take a bite of the apple might be to buy an index fund, but this can be risky. Because of their overweighting in things like financials, the Chinese indexes can often fail to reflect the diversity of the country. When you buy an index in the U.S., you're often getting a good snapshot, says Trippon, but with China that's not the case.

"The main Chinese index people refer to in the United States is the FXI," Trippon says. "It's 25 companies. That's not a representative sample of their economy, not like you would get if you bought the S&P 500 or the Russell 1000." Trippon thinks investors should avoid open- and closed-end funds that invest directly in China; he seeks cheap companies on the Hong Kong and New York exchanges.

Gao also looks askance at the indexes. He says the Matthews fund uses the MSCI China Index as its benchmark. "But it's not really a good representation of the real economy in China [because it's] quite overweight in certain industries. I think the top 10 or maybe less, the top five companies of the MSCI index account for probably around 38% to 40% of the index. Also, it has a very heavy weighting in financials and energy."

His fund instead seeks more diversity with overweight positions in consumer discretionary, consumer staple and technology companies. He likes companies such as Ctrip.com, an online travel service that plays on the country's booming tourism industry, and Ping An, a massive insurance player with a presence all over the country that has been diversifying into other forms of financial services and has taken on big investments from Western financial behemoths such as HSBC.

Franklin Templeton's Sleeman likes Australian conglomerate Seven Network, which sells Caterpillar equipment in China, a play on infrastructure. Because his fund doesn't like banks, the company has gotten financial exposure through a company called CNinsure, an insurance brokerage business that allows the fund another way to take advantage of increased car and home ownership.

The Franklin Templeton fund also invests in Volkswagen, a huge player in China, to get a piece of the booming car market. "China has overtaken the U.S. as the major consumer of auto vehicles, and we interestingly have an exposure to that through Volkswagen because Volkswagen's always been [a] leader in the Chinese market, and again they're moving up the value chain," Sleeman says. "And Audi sales have just been stupendous."

Trippon disagrees with the last strategy, saying China can't save a company suffering elsewhere. For example, he says, General Motors is the No. 1 car company in China, which is now the world's No. 1 car market. But that doesn't mean investors would want it (the troubled GM, after emerging from bankruptcy last year, is now owned mostly by the U.S. government and is looking to re-emerge in an IPO).

In China, Trippon says, "They love the Buick for some reason. God knows why, but they do." But, "The fact that [General Motors] is the biggest foreign car manufacturer in China isn't sufficient to offset their other problems."

Trippon thinks an alternative way to play the auto market might be to invest in the country's two gasoline companies, Sinopec or PetroChina, though he concedes these companies might not appeal to value investors.

Del Ray's Hechmer adds that if everyone's trumpeting Volkswagen for its huge market share in China, that euphoria may already be priced into the stock-so value investors beware. Furthermore, Chinese buyers also have local brands they can buy. Which means Volkswagen might not be much better than a commodity investment. "Volkswagen has nowhere near the barriers to entry in China that some copper producer has," he says.

Another consumer play is China Mobile, which trades on the New York Stock Exchange as CHL.

"CHL is one of their national cell phone companies and they have something like 400 million or 500 million customers," Trippon says. "And whether they have exports or don't have exports, the wife is still going to call her husband on the way home from work." He also mentions Chinese pharmaceutical or health-care companies, since the Chinese government is on a spending spree to improve health care in rural areas and the Chinese consumer with expanding per capita income now has more money to pay for his own health care.

On the whole, say observers, the Asian countries have become more interdependent, with China the nexus drawing it all together, a country that's outsourcing its cheap labor and now serving as the main export destination. "We think the best approach [in the region] is two-pronged," says Mark Luschini, the chief investment strategist at Philadelphia's Janney Montgomery Scott. "Invest in globally geared companies selling into these markets and at the same time consider allocating cash to emerging markets vehicles through a mutual fund or ETF to get direct exposure to the growth that should remain relatively strong, especially when compared to developed countries, for years to come."