100 Flowers Blooming:
Picking a Bouquet of Stocks as Spring Comes to China

By Crocker Coulson

       As the weather turns balmy in Beijing, spring has come to the China equity markets as well – with “green shoots” sprouting across to the industrial heartland of the Middle Kingdom and green screens washing away red on the trading screens of China-focused fund managers. Since March 2nd, the Halter China Index of all Chinese stocks trading on a major U.S. market has rocketed up 62 percent. Over that same period the Hang Seng China Enterprise Index of HK-listed Chinese “red chips” has gained about 46 percent, while the Russell 2000 Index of U.S. small caps is up 28 percent. The China growth story is back and funds have started flowing back into Chinese equities that had been left for dead in the fall of 2008.

Halter China Index, March 2-May 8, 2009

       What is driving this surge in performance?

       It has become increasingly evident that China’s stimulus spending plan is having its desired effect of picking up industrial demand and at least partially compensating for the drop-off in exports due to the global recession. In late April, Goldman Sachs raised its growth forecasts for China’s GDP to 8.3 percent in 2009 (up from 6 percent) and to a sizzling 10.9 percent in 2010 (from a prior 9 percent). Support for housing, infrastructure and rural consumption has revived demand for basic industrial materials such as cement and steel and has begun to cause a turnaround in pricing for commodities such as iron ore and copper. China’s banking system has loosened the monetary and credit taps, sending liquidity streaming into the corporate and real estate sectors and rekindling fixed investment. The confidence of China’s CEOs is sharply improved from only a few months ago, leading corporations to forge ahead with expansion plans.

For several years now, China’s government had been seeking to tamp down hot money inflows, real estate speculation, and credit availability in order to prevent economic overheating and inflation. For this reason the effect of the combined fiscal and monetary stimulus has been immediate and pronounced. The result has been a whipsaw market in which sectors such as property, transport and materials, from which investors fled en masse just months ago, have shown some of the most dramatic equity price gains on the Hong Kong exchange since the market turned in early March. The realization is building that China is positioned to come out of the global downturn faster and stronger than the developed economies – fueled by an underleveraged consumer, a solvent banking system, and a fully funded, rapidly deployed government stimulus plan.

Dead Cat Bounce?

       Skeptics may argue that one of the greatest reasons for the dramatic recovery in U.S.-listed Chinese shares is simply that they had fallen so dramatically in the preceding quarters, wreaking carnage on the portfolios of anyone unlucky enough to hold them during 2008. Even a dead cat bounces when it hits the ground, the Wall Street adage has it. Looking at the top performers during the first quarter suggests there is some truth to this. While some of these names such as AgFeed (NASDAQ:FEED) and China Shenguo (AMEX:KUN) are up smartly in 2009, at 127% and 107% gains respectively, they have each lost nearly 80% of their value over the last year. In some cases the stocks have risen following dramatic downward resets in earnings expectations for 2009, calling into question how sustainable the rally in their shares will be.

An extreme example is the third strongest performer among China names this year, Fuwei Films Holdings (NASDAQ:FFHL), whose shares have gained 114% in 2009. Fuwei recently disclosed that its three major shareholders were found guilty by the Jinan Intermediate People’s Court of misappropriation of state-owned assets during the legal reorganization prior to Fuwei being listed as a U.S. public company. One shareholder, Mr. Jun Yin, has been sentenced to death and the other two to life imprisonment. Their 65 percent ownership has now been transferred back to the Chinese government, making Fuwei, with a market cap of just $20 million, most likely the smallest State Owned Enterprise (SOE) listed in the U.S. markets. Investors that bought Fuwei’s shares in early 2007, before the issues with Fuwei’s management and subsequent deterioration in business outlook were disclosed, have lost 90 percent of their investment.

Looking at the leaders and losers for the past 52 weeks suggests that fundamentals do play a more determining role in stock performance with the passage of time. The strongest performers, including Shanda Interactive (NASDAQ:SNDA), AsiaInfo (NASDAQ:ASIA), and China Sky One (NASDAQ:CSKI) have shown steady earnings growth and strong operating cash flows over a series of quarters, resulting in positive returns both over the short and longer term. The top decliners feature a number of companies that once sported rich valuations but have subsequently disappointed market expectations with a series of weak earnings reports.  This includes the once seemingly unstoppable purveyor of elevator ads Focus Media (NASDAQ:FMCN), 3G-communications chip provider Spreadtrum (NASDAQ:SPRD), and biodiesel behemoth Gushan (NYSE:GU) – all off over 80 percent from where they traded a year ago.

A Long, Hot Summer for Chinese Stocks

Despite the gains of the past two months, there are a number of reasons to believe that enormous opportunities remain for investors with the persistence to carefully research and select the most promising growth stories from China.

First, Chinese companies are operating in a macro-economic environment that is likely to be substantially more conducive to growth than their U.S. counterparts over the next five years. While China’s base-line GDP growth is likely to moderate over time from the double-digit rates experienced in recent years, the fundamentals sustaining that growth are likely to be more sustainable. The global recession has moderated upward pressure on labor and commodities, taken the air out of a looming property bubble, and refocused Chinese management on capital allocation and expense control. The Chinese government is now deeply committed to stimulating domestic consumption, bolstering rural incomes, and weaning its manufacturing sector off a dependence on the debt-soused American consumer. New plans for healthcare and education reform should help to scale back the Chinese consumers’ excessive savings rate and redress some of the income inequality that has built up during the export- and urban-focused phase of China’s recent economic development.

Second, China’s economy continues to contain significant inefficiencies on a micro-economic level that create enormous opportunities for well-run and ambitious listed companies. As an example, many industries have significant structural barriers to entry that enable well-positioned and efficient companies to earn significantly higher profit margins and returns on capital than one would expect in a developed economy. A combination of licensing requirements, local distribution practices and government support through infrastructure, land grants and tax breaks can effectively prevent foreign players from competing away these profits and allow companies to build scale advantages in a relatively short period of time. In addition, Chinese entrepreneurs are often presented with opportunities to make acquisitions under very attractive terms that would never be available in more developed markets with open auctions and widely shared information on asset markets. In fact, most acquisitions are negotiated in China on the basis of net asset value – which may have little or no bearing on the value of a target’s earnings power or projected cash flows. While larger companies and SOEs currently have greater latitude to take on bank debt, smaller private companies have extremely limited access to equity capital or long-term debt – creating an acute capital shortage that should result in abundant consolidation opportunities for companies that can access the overseas financing market. For all these reasons, it is likely that the strong will get stronger and the corporate landscape of China Inc. will undergo meaningful consolidation over the next few years.

Third, valuations remain extremely undemanding, particularly for the less liquid and less well-known Chinese growth stories. In January and February of 2009 one could find dozens of stocks with reasonably good growth prospects and solid margins trading at 1-3X earnings. Even after the recent rally, many names that are likely to grow their earnings at 30 percent or better for the next several years are trading at PEs in the low single digits. These U.S.-listed Chinese stocks are trading PEG (price-earnings-to-growth) ratios far below what U.S. companies with comparable performance would fetch (assuming that such companies could be found) and massive discounts to comparables on the Shanghai and Shenzhen stock exchanges – despite offering generally better growth rates, higher quality accounting and higher margins than the A-share names.

Finally, U.S. investors remain irrationally under-exposed to Chinese equities. According to data released by the Federal Reserve, in 2008 China ranked number 13 in the world in holdings of foreign equities by U.S. investors – well behind such economic flyspecks as the Netherlands (#7), Australia (#8), and Spain (#11). U.S. investors held only $96 billion in Chinese equities, as compared to $734 billion of U.K. equities. Unless one believes that the English and the Dutch are destined to be the dominant economic powers of the 21st century, this allocation makes no sense. At some point American retail and institutional investors will wish to increase their stake in the fastest growing major economy in the world, which will presumably drive up the price for these shares.

There is no question that investing in Chinese companies entails very significant risks, largely relating to the different business culture in China and corresponding lack of investor confidence in the completeness, accuracy and timeliness of financial and business information. Gradually, Chinese management teams are beginning to realize that greater transparency and consistency will translate to higher equity valuations. But this remains very much a “work in progress” and investors are exposed to substantial information asymmetries and frequent surprises.

Brilliant Flowers and Poisonous Weeds

So what should investors look for when sorting out the brilliant flowers from the poisonous weeds in the bright and blooming field of Chinese equities?