How to Invest in China

Here are seven suggestions for investors who are wondering if investing in this market is worth the risk.

With CEO Allen Chan's departure from Sino-Forest earlier this week and the halt in trading of its stock, many investors are scratching their heads and wondering how or if they should invest in China.

I've even heard some commentators on TV say that since the Shanghai index has been flat or down in the last few years, this is proof that China is not a great place to invest. Yes, but most people invest in particular stocks. For example, i\If you bought into Baidu (BIDU) at its March 2009 levels and held on to it until today, you would be up 845%. That's not bad.

Of course, if you've invested in Sino-Forest or some of the other Chinese frauds, you have taken massive hits.

So how should you proceed? Here's my advice.

1. Don't ever put your money in a Chinese Reverse-Takeover (RTO) again. There might be some good ones out there, but I can't name any. It's not worth it. There is way too much risk for the potential return.
2. Don't think a Big Four auditor is a guarantee that everything at a Chinese company is kosher. Longtop Financial had one. So did China Agritech. Both are now trading on the pink sheets.
3. Don't think a big name investment bank is a guarantee that a company is legit. Goldman Sachs (GS) took Longtop public a couple of years ago.
4. All things being equal, it's safer to invest in the bigger-cap Internet companies in China -- and they are less likely to manipulate numbers compared to a manufacturing companies over there. The big dogs of the Chinese Internet are Tencent, Baidu, and Alibaba Group. Alibaba is still private but Yahoo! (YHOO) owns 40% of it, which is why I love Yahoo! Sina (SINA) is trying to break into this small group of big dogs and probably will in the next couple of years as its Weibo users grow.
5. Beneath the "big dogs," there is much more risk, so pick category winners. Sina is the category winner in Weibo (Twitter). Youku (YOKU) is the category winner in online video. Taobao (part of Alibaba Group) is the category winner in e-commerce.
6. Look for value plays. Online gaming in China is severely undervalued at the moment -- especially compared to the expected valuation that Zynga is going to get when it launches its IPO. My two favorites in that space are Perfect World (PWRD) and Giant Interactive (GA). I also think Mecox Lane (MCOX) is massively undervalued compared to Dangdang (DANG).
7. There are no guarantees in China. The Chinese government could rewrite the rule book tomorrow. The whole Alipay incident with Yahoo! shows the risks of Chinese investing. Just as it's possible in the U.S., There could be a big accounting restatement in any of the "big dogs" at any time. However, I think there is still another 18-36 months of growth ahead for China before a major correction, so opportunity does beckon for the right companies.

At the time of publication, Jackson was long YHOO, SINA, PWRD, YOKU and MCOX, although positions can change at any time.