The worlds’ biggest: country, exporter, Internet market, consumer of energy, producer of wheat, and more recently, the second largest economy, China is expected to be an engine of global growth for decades to come. However, the repercussions of the prolonged global recession, coupled with a number of near term concerns, including a slowdown in the pace of economic growth, inflation and the possibility of a real estate market bubble, have resulted in the undervaluation of many Chinese stocks.

Last month, a key indicator of Chinese economic strength, the HSBC Purchasing Managers’ Index (PMI), slipped to its lowest level in more than a year, signalling that a slowdown is unfolding. A proxy for industrial production, the PMI showed a decline in demand for manufactured goods, primarily as a result of soft domestic demand. The weak result also coincided with the International Monetary Fund’s (IMF) call for China to implement reforms to ensure that growth remains stable.

At the same time, however, HSBC Holdings Plc’s (NYSE: HSBC) co-head of Asian economic research said that: “Despite the slowing of manufacturing activity, resilient consumer spending and continued investment in thousands of infrastructural projects will continue to support Gross Domestic Product (GDP) growth…” Furthermore, according to the IMF, even a struggling China is expected to see its economy expand by 9.6 per cent in 2011. While that is down from 10.3 per cent in 2010, it could account for more than 30 per cent of the world’s total. Notably, annualised economic growth continued to be high at 9.5 per cent in the second quarter of 2011, only slightly below 9.7 per cent for the first quarter.

Yet, the MSCI China Index currently has a 12-month forward price/earnings (P/E) ratio of 10.4 times, the lowest in over two years and approximately a 17 per cent discount to that of the Standard & Poor’s (S&P) 500 Index. It hasn’t been cheaper since the beginning of 2009, and over the course of that year it returned a 58.9 per cent gain, more than double the S&P 500 Indexes’ 26.5 per cent. This may be why many stock analysts at some of the world’s largest banks, including HSBC, Credit Suisse Group AG (NYSE: CS), and Citigroup Inc (NYSE: C) are now issuing buy recommendations for Chinese stocks listed both in Hong Kong and the Mainland. According to HSBC, China’s stocks will outperform the rest of Asia this year as inflation slows and the political stalemate over US debt ends.

One of the safest ways to tap into the Chinese market is by investing in US-based companies with Chinese operations that account for a significant portion of revenues and earnings. For example companies such as Yum! Brands, Inc (NYSE: YUM) — 36.5 per cent from China, McDonald’s Corp (NYSE: MCD) and Apple Inc (NASDAQ: AAPL) — 21 per cent and 12.7 per cent from Asia, respectively. However, others may want to invest in Chinese Companies listed in the US, such as NetEase.com, Inc (ADR) (NASDAQ: NTES), to seek higher returns. NTES has gained 26 per cent year-over-year (yoy) and 37 per cent year-to-date (YTD) to US$50.52 (close on August 1, 2011).

A prime example of an undervalued Chinese stock with growth potential is Blue chip company, China Mobile Ltd (NYSE: CHL). CHL is the largest mobile operator in the world (annual revenue is greater than its two largest competitors, China Telecom Corp Ltd (NYSE: CHA) and China Unicom (Hong Kong) Ltd (NYSE: CHU), combined). With a payout ratio of 43.31 per cent, CHL has an attractive dividend yield of 3.5 per cent and has increased its dividend payments by an average of 24 per cent over the past five years. Furthermore, the company has a solid balance sheet that provides it with flexibility to continue to boost its dividends going forward.

Looking at its financial performance, CHL has shown consistent growth over the past five years, averaging approximately 19 per cent annual growth in both earnings and revenues. There has also been widespread speculation that the company will begin carrying AAPL’s iPhone, and if this comes to fruition it would significantly improve revenue growth. Furthermore, mobile phone penetration is approximately 59 per cent in China, compared with 90 per cent in the US, leaving CHL with potential room for growth. Notably, the company grew its subscriber base by 12 per cent in 2010 or 60 million new subscribers in only a year.

In terms of valuation, the stock is currently priced at US$49.84 (close on August 1, 2011) or at around 10 times trailing earnings compared with the aforementioned Chinese competitors, which trade at 19 and 100 times respectively. With low leverage and strong growth prospects, CHL appears to be the “bargain” of the sector and seems poised to gravitate towards its pre-recession high of US$104.14. The stock has declined marginally since the start of the year, presenting a good buying opportunity as the near-term price target is US$55.00.

Investors could also consider investing in CHL and other Chinese stocks on the Hong Kong Stock Exchange, which has been the go-to market for Chinese companies looking to list beyond their home borders. In 2011, 62 per cent of Chinese Initial Public Offerings (IPOs) were listed in China, 34 per cent in Hong Kong and just four per cent in the US. Furthermore, while Baidu.com, Inc (NYSE: BIDU) has gained 1,643 per cent since the end of its first day of trading in 2005, Chinese companies listed in the US tend to underperform those listed in Hong Kong. The median five-year gain for a Chinese company currently listed on the New York Stock Exchange or Nasdaq with a five-year track record has been 36.9 per cent, compared with 60 per cent for Chinese companies listed in Hong Kong.

Going a less conventional route, investors could also invest in the SPDR S&P China Exchange Traded Fund (ETF) (NYSE: GXC), which includes 130 Chinese stocks listed in both Hong Kong and the US, trades more than 100,000 shares a day on average and has an expense ratio of just 0.59 per cent, the lowest among China-region ETFs. The fund is up four per cent yoy to US$77.24 (close on August 1, 2011).

So investors have various options to gain exposure to China. While growth has tempered, this is in part due to policymakers’ strategy via tighter monetary policy in an effort to counter inflation. And, the general consensus is that the tightening cycle is near its end. Furthermore, the Chinese government has been aiming to stimulate growth through more expansionary fiscal policy — from cutting taxes on the poor and middle class to funding public housing. These steps, in turn, are likely to boost construction, consumer spending and already strong domestic demand. Moreover, as global economies rebound, demand from overseas will keep China’s boat afloat.

Therefore, investors should take a second look at the potential opportunities that this emerging market presents. Ponder these questions, would you pass up an opportunity to buy Microsoft Corp (NYSE: MSFT) 25 years ago? How about AAPL or MCD in the 1980s? As billionaire investor, Warren Buffet said, “most people get interested in stocks when everyone else is. The time to get interested is when no one else is. You can’t buy what is popular and do well.” The same applies for Chinese stocks — just don’t forget to focus on the fundamentals (a history of solid financial performance, diversification and innovation and a sound management team) when making your investment choices.

Deirdre Witter is an Investment Analyst at Stocks & Securities Ltd. You may contact her at dwitter@sslinvest.com.