Market Overview, August 2009

China’s property sales surged 60% by value in the first 7 months, adding to concern that record lending will create a real estate bubble in the world’s fastest-growing major economy.

Stocks in the countries that have produced the most dramatic economic growth over the past decade – think China, India, Brazil, and the like – have on average delivered just 6% returns to investors. That’s compared to 12% returns in the world’s slower-growing developed nations.

The reason for this, of course, is valuation. Tech giants such as Microsoft (Nasdaq: MSFT), Cisco Systems (Nasdaq: CSCO), Dell (Nasdaq: DELL), and Hewlett-Packard (NYSE: HPQ) have produced negative returns since 1999, despite growing their revenues at more than 10% annually during the same period, because investors bid their stock prices up too high. The same goes for stocks in emerging markets.

Investors see the eye-popping development taking place in China and Brazil – and, yes, that development is real – but they end up paying far too much to get a portion of it in their portfolios.

In other words, there’s a valuation trap when it comes to investing in high-growth emerging markets. In order to capture their growth, therefore, you need to be willing to buy into them when their valuations plummet, which is usually when some kind of economic crisis strikes.

Did you say “economic crisis?”

In fact, we’ve just experienced one of those times. Chinese stock valuations were absolutely pulverised in the period from October 2008 through as recently as May 2009, as freaked-out investors pulled their money out of any and all stocks they perceived as “risky.”

Of course, returns of that magnitude mean that money is flocking back to emerging markets, causing valuations to rise. That, in turn, means the window to earn outsized returns in emerging markets is closing.

Are there still windows of opportunity?

There are two economic realities in China. The first is the reality of coastal China i.e. the part of China everybody knows about. This is the China of Beijing, Shanghai and Shenzhen – the massive cities that have led China’s rapid economic growth for the past 25 years.

The other China, however, is western China; the China of relatively unknown provinces such as Inner Mongolia, Shaanxi, and Xinjiang. These are the poorest parts of China -regions that have been largely left behind by China’s economic development.

The headline for prospective investors in China, however, is that this is starting to change.

Thanks to massive government spending to raise rural incomes and even out infrastructure development across China, western China is now the country’s fastest-growing area. In fact, that part of the country is growing at more than 11% annually, versus just less than 9% for the rest of the country. Inner Mongolia, has been the fastest-growing province of all, posting incredible 16% annual GDP growth from 1998 to 2008.

Why does this matter?

According to research, companies in the developed parts of China currently trade for more than 25 times earnings. Companies in rural China, however, trade for just 13 times earnings.

Put another way, the companies in the fastest-growing parts of China are today also the cheapest – exactly the opposite of what we would expect.

This is why we see enormous opportunity in investing in rural China today, and why I’m now considering a trip to Inner Mongolia.

Your choices: The emerging-market investment window is closing, and the market will eventually catch on to the opportunities it’s missing in rural China.

Naturally, you want to buy in before that happens.